Stock Up on "Discounted" Value

When value investors look at a company, one of the main points of contention is often the discount rate. We use this rate to determine the value of a company's future free cash flows. There are two main factors that affect the discount rate: the company's capital structure and its operating structure.

Capital structure
Capital comes from two main sources: debt and equity. The ratio between the two amounts starts to define the capital structure of a company, which affects a company's cost of capital or discount rate.

Debt capital is usually less expensive than equity capital, since debtholders assume less risk. So if a company takes on debt, it can lower its overall cost of capital, resulting in lower interest payments.

For instance, take Outback Steakhouse (NYSE:OSI), the down-under restaurant chain, and IronMountain (NYSE:IRM), the document storage and management company. Each has been using debt to finance its expansion plans. Without any additional information, we would assume that their cost of capital is decreasing. But that's not quite correct. We not only need to look at debt in relation to equity, but also at coverage ratios -- the relationship between EBITDA and interest expense.

You can see that the debt/equity ratio for both companies has been increasing over the last four years. But notice that Outback has considerably more room to make its interest payments. Even though Iron Mountain has performed well and lowered its cost of capital by using debt, I would raise its discount rate because of this added risk.

The bottom line is that the context of the debt requires us to make adjustments using our judgment about risk. Yeah, it makes my head hurt too.

Operating structure
A company's capital structure directly affects its cost of capital, and thus its discount rate. But I think a company's operating structure, the ratio of fixed costs to variable costs, offers significantly more insight into risk than the previous two.

One of the most important things Roberto Goizueta did as head of Coca-Cola (NYSE:KO) was to spin off its bottlers in 1986. This move significantly reduced the parent company's fixed costs. Selling syrup to the bottlers requires significantly less capital than converting the syrup to soda and distributing it. Fixed costs moved to the bottlers while variable costs stayed at the parent, significantly lowering Coca-Cola's cost of capital.

Southwest Airlines (NYSE:LUV) and U.S. Airways (NYSE:LCC) are two more great examples of the importance of operating structure on value creation.

Airlines are almost entirely made up of fixed costs. The only variable costs, costs that change directly with sales, are the snacks. Regardless of the number of passengers on the plane, fuel costs are fixed, gate costs are fixed, maintenance costs are fixed, service costs are fixed ... you get the point.

U.S. Airways has gone bankrupt twice because it weighed down its fixed-cost operating structure with an additional huge fixed-cost burden, only to see revenue fall amid intense price competition. Meanwhile, Southwest has used debt more conservatively, increasing its profitability during the same time frame. The table below shows the extreme pressure U.S. Airways put itself under by adding fixed costs to a fixed-cost structure.

Debt-to-Equity Ratio

Two things to remember
I know I'm repeating myself, but it needs to be said again: Estimating discount rates is very difficult. But from the examples above, here are a couple things the analysts at the Motley Fool Inside Value newsletter team look for (and none of them have to do with beta). Think of discount rates in terms of direct costs and opportunity costs:

1. Pay attention to the amount of debt relative to equity and to interest coverage ratios.
2. Companies with lower fixed costs can be less risky.

The Foolish bottom line
As value investors, understanding the discount rate and how to apply it is crucial to determining what price we are willing to pay for an investment. Since we don't want to pay too much for a great story, we must be mindful of risk and its impact on discount rates. That's where Philip Durell focuses his attention to help the Fool's Inside Value newsletter beat the market. So take a 30-day risk-free trial today. With a discount rate of zero, you get to keep all of the value created!

For more on value creation, check out:

• The Sweet Smell of Money

David Meier does not own shares in any of the companies mentioned. Coca-Cola is an Inside Value pick. The Motley Fool has a disclosure policy.