A basic tool of fundamental investors, and especially value investors, is the discounted cash flow calculation of present value. How to establish the discount rate in DCF is addressed in chapter seven of "Strategic Value Investing: Practical Techniques of Leading Value Investors".

Authors Stephen Horan, Robert R. Johnson and Thomas Robinson previously discussed present value and estimates of cash flow in other sections of chapter seven, a chapter titled, "Dividend Discount Models."

The discount rate is a critical input of the DCF model. Here is an example, using the calculator at GuruFocus to determine the fair, or present, value of Microsoft (NASDAQ:MSFT) and starting with a 12% discount rate:

Next, here's the calculation using a 9% discount rate:

Notice the significantly different fair value outcome generated by the two different rates:

- The 12% rate suggests the value of future cash flows, discounted back to the present, is $56.07.
- The 9% rate suggests the value of those same cash flows, again discounted back to the present, is $70.65.

Neither of these rates provides a margin of safety when the price is $134.44 (as it was on Aug. 26), so value investors aren't likely to buy Microsoft stock at its current market price. However, if the price was in, let's say, the mid $60s, then the choice of an estimated discount rate would be very important.

All discount rates originate in the same place, with an interest rate. Because there are so many variables involved in stocks, everything from market conditions to earnings growth, the interest rate is usually adjusted. The discount rate becomes the interest rate plus adjustments. The authors wrote:

"We cannot specify one discount rate to use for all investments at a particular point. In addition, discount rates for all securities will vary through time as market conditions change. Specifically, the discount rate will vary according to several conditions, including the returns (or yields) on other investments in the marketplace, as well as the perceived riskiness of the dividend stream being analyzed."

Regarding risk, it is usually assessed in comparison with riskless U.S. government securities. The greater the risk, the higher the discount rate should be; the difference between the risk-free rate and the risk involved with a security is referred to as the risk premium.

Some investors establish the risk premium by using the capital asset pricing model. Its formula looks like this:

While it's nice to have a formula for establishing the market premium, investors still must make estimates to quantify the inputs. A common solution to this is to use historical data; for example, the average annual return on large-cap stocks between 1926 and 2010 was 11.9%, while the average return on government bonds over the same period was 5.9%. The difference between the two averages is 6%, and that would be the risk premium or the market risk premium.

A second input of the CAPM formula is beta, a comparison of the price volatility between a specific stock and the market at a whole. Stocks with a beta of more than 1 are considered more volatile than the market and those with a beta of less than 1 are considered less volatile. Put another way, if stock A has a higher beta than Stock B, then investors would demand a higher return for Stock A. This, too, would push up the discount rate for A.

To further illustrate, the authors provided the discount rate calculations for General Electric (NYSE:GE), which had a beta of 1.47 at the time the book was written, and Johnson & Johnson (NYSE:JNJ), which had a beta of 0.45.

First, the rate for GE, which works out to be 12%:

And the rate for Johnson & Johnson, which comes in at 6%:

So these are discount rates for two different stocks, using the dividend discount model and CAPM. The authors summarized, "All else equal, the cash flows expected from Johnson & Johnson will equate to a higher present value than identical cash flows from General Electric because they are considered less risky."

They added that the CAPM and beta models are "far from perfect" because they are based on many assumptions, including the concept that investors will behave rationally. Put another way, part of the art of investing is in making good assumptions and estimates.

To simplify the process, some professional investors might use the build-up method; it originates with the risk-free rate (from government bonds) and adds to it based on three criteria:

- Equity risk premium: This reflects the amount of additional risk an investor takes on by investing in stocks rather than government bonds. This premium might come from the historical difference between stock and bond returns, as shown in the example above.
- Stock capitalization premium: Stocks generally get safer as their capitalization increases, so mid-cap stocks are seen as riskier than large-cap stocks, and small caps are considered riskier than both. From a historical perspective, mid-cap stocks have a long-term risk premium of roughly 1%, small caps 2%, and micro caps 4%.
- Specific premiums: Individual company factors, such as the level of indebtedness or degree of liquidity. A stock with a lot of leverage is considered riskier, as is a private company since its stock is relatively illiquid.

The authors noted the total of those three factors plus the risk-free rate "build up" to the required rate of return, which may also be called the desired return or the discount rate. And, "As a value investor, you want to only buy securities with a sufficient margin of safety, so it is generally best to be conservative in your assumptions and specifically err on the side of overestimating risk premiums."

Even simpler is Warren Buffett (Trades, Portfolio)'s approach to the discount rate. The authors report he stated at his annual meetings in the late 1990s he generally uses a long-term treasury rate. That allows him to set a preliminary value and he will only buy a stock if there is a "significant" discount to it. For example, in the late 1990s, the U.S. Treasury rate was about 7%, so he would want at least a 10% discount rate on a stock.

The distance from the Treasury rate would reflect his level of comfort with the company, which is to say how certain he was about his estimates of its future cash flow.

**Conclusion**

Without a reasonable discount rate, the odds of getting a stock valuation reasonably right are low. In this section of chapter seven of "Strategic Value Investing: Practical Techniques of Leading Value Investors," we have been given tools to help establish the rate.

I say "reasonable" because discount rates cannot be calculated with scientific precision; instead, they are the estimated sums of a risk-free rate plus a risk premium established by the CAPM model. Alternatively, it might be based on the risk-free rate plus the equity risk premium, the capitalization premium and company-specific premiums. Establishing each of those premiums is as much an art as a science.

But the power of our art can be increased with knowledge and the appropriate application of that knowledge.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

Read more here:

- Strategic Value Investing: Estimates of Cash Flows
- Strategic Value Investing: Dividend Discount Models
- Strategic Value Investing: Absolute and Relative Valuations

Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.

This article first appeared on GuruFocus.

- Warning! GuruFocus has detected 5 Warning Sign with MSFT. Click here to check it out.
- MSFT 15-Year Financial Data
- The intrinsic value of MSFT
- Peter Lynch Chart of MSFT