How Warren Buffett and Charlie Munger Discount Future Cash Flows
Hint: They don’t do it like Wall Street
If there’s one subject that confuses finance students (and grownup investors) more than any other, it’s discounting future cash flows.
Discounted cash flow (DCF) models are the foundation of modern financial analysis. The basic idea behind discounting is that a dollar today is worth more than a dollar in the future.
If you could somehow figure out how much cash a company would generate over its entire lifetime and “discount” those future dollars back to the present day, you would know how much the company is worth.
Warren Buffett often invokes Aesop in explaining the concept:
The formula for value investing was handed down from 600 B.C. by a guy named Aesop. A bird in the hand is worth two in the bush.
Of course, Aesop forgot to mention a few other elements.
- How many birds are in the bush?
- When are you going to get them out?
- What is the discount (risk-free) rate?
Wall Street analysts get paid a lot of money to answer these questions. They build complex DCF models with many variables, ultimately arriving at a precise figure of what the business…
