Someone was Googling "why does warren buffett discount cash flow at the risk free rate". The answer is that, as a large financial institution, Berkshire Hathaway borrows money at the risk-free interest rate. An insurance contract has an implied interest rate at which you borrow money. For example, suppose that Berkshire Hathaway sells $1B of hurricane insurance for $100M, and there's a 1 in 10 chance of a hurricane. Superficially, this is not profitable. However, the premium of $100M is collected before the payment of $1B is made. Effectively, Berkshire Hathaway is borrowing money at a 0% interest rate.
The interest rate implied by an insurance contract will always be less than the Fed Funds Rate. Otherwise, Berkshire Hathaway would be better off borrowing from the Federal Reserve instead of writing insurance.
Therefore, it is correct to discount cashflow at the Fed Funds Rate. Berkshire Hathaway is borrowing at less than the Fed Funds Rate and investing in tangible assets.
Warren Buffet has discussed the "discounted cashflow paradox" in one of his annual meetings. The correct answer to the "discounted cashflow paradox" is that the long-term value of a dollar is zero. If you lend money at the Fed Funds Rate, then your purchasing power is eroded by inflation faster than you are credited with interest.
Friday, October 10, 2008
Warren Buffet and the Discounted Cashflow Paradox
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2 comments:
Why would anybody lend at the Fed Funds rate of 0% so a third party can invest at 20%, when the lender can invest at 20% himself? Just invest at whatever the third party would have invested in. If I'm gonna lend to some third party, I want at least the return on that investment as interest, otherwise I can just make that investment myself. But the third party can't pay more than the return (where's it gonna come from?). So that means the interest rate must equal the return on investment.
There is no paradox in a free market. There is no such thing as a "risk free rate" in a free market. Borrowing at the "risk free rate" is the same thing as borrowing a printing press (which has an INFINITE VALUE). The "risk free rate" is the price of paper and ink over time.
Of course there's an infinite value in borrowing at 0% and investing at 10% (if you do that for an infinite period of time)! But if you borrow at 10% and invest at 10%, that has a finite value. And if you borrow at 20% and invest at 10%, that has 0 value (if I borrow $1000 to start a business and I owe $1200 in a year but my business is only worth $1100, I just lost $100!).
The discount rate MUST BE the return on capital to get a finite value!
The infinite value is the infinite amount of everyone else's goods and services stolen by inflation. It means you can profit by leveraging OTHER PEOPLE'S money without giving them the full return! And WITHOUT THEIR PERMISSION!
If the interest rate is the return on capital, there is no way to profit from other people's money. And there shouldn't be. It means your business can only grow by providing USEFUL GOODS AND SERVICES.
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