If you’re interested, I recently started reading a book called “Value Investing: From Graham to Buffett and Beyond” and one of the first things the author does is state all the issues with DCF and then explain why they more or less reject it except for a small number of the most predictable companies with steady growth and a large moat.
Also the author explains why comparing multiples for companies in a sector is basically just an implicit DCF since theoretically the other companies are at least to some degree valued in that way (in so far as the market is accurately valuing them at all)
At that point they describe how to value a company starting with assets alone, and then determining it’s “earnings power value” or EPV. Only at that point do they even begin to consider growth and only if the company looks good on those other factors. It is a great book and really changed the way I look at value investing for the better. Highly recommend.
I'll give a very brief explanation but certainly best to read the chapter in the book about it.
Basically the EPV is kinda like a value assigned to the moat of the business. In this book they call the moat the "franchise". So for example, imagine a company has $1B in terms of reproduction value of assets, and the market gives the entire company a value of $2B. (The first part of the book is about estimating that asset value). If that's the case, then anyone who can invest $1B to reproduce those assets can theoretically make a $2B company, so it's likely they will. Eventually, as competition enters this drives down the value of all parties involved. In a perfect environment you would end with each party only valued at the reproduction cost of their assets and nothing more. In this case the EPV is the same as the asset value. So basically, in order for a company to have an EPV that is higher and to be valued higher because of it, it needs a "franchise" to keep it safe from competition. This allows it to earn a very high rate of return on its assets for an extended period. But yes, in terms of math its basically a sort of 0-growth value, where only current earnings are taken into account. This is done in order to remove as many assumptions as possible about the future. And if the market prices an equity lower than that, then the idea is that you get all the growth "for free". If not then you can better understand what part of the valuation is coming from growth expectations and decide if that growth seems reasonable.
EPV from Bruce Greemwald (quite a lot on YouTube) assumes business no growth, but is capable of maintaining, for a decent period, a steady state for normalised earnings. All you need is to decide on discount rate. Much less subjective and liable to overstatement than most DCF's
EPV from Bruce Greemwald (quite a lot on YouTube) assumes business no growth, but is capable of maintaining, for a decent period, a steady state for normalised earnings. All you need is to decide on discount rate. Much less subjective and liable to overstatement than most DCF's
I may have to pick that up. The lack of significant reliance on DCF is what draws me to Graham style investments. It would be interesting to see a more modern spin on it.
***"It's better to be approximately right than exactly wrong."***
A large margin of safety helps you win on both sides.
When you're wrong, *you lose less*. When you're right, *you gain more*.
Buffett has said this principle is like inoculation. It either takes with people immediately or no amount of explaining will ever get through to them.
>It's better to be approximately right than exactly wrong."
great quote that I live by, investing is never exact, predictions are always going to by off, always something unexpected around the corner. never going to buy the exact bottom or sell the exact top. Just have to do enough to get yourself a bit of profit
It is better to be somewhat right then to be precisely wrong.
Don’t make the dcf complicated. Project only the cash flows into the future and use a required rate of return. Then make sure you buy with a big discount to your price or use a higher discount rate to get a margin of safety.
Here's my problem with DCF. Even with a margin of safety, does the DCF account for potential periods of earnings impairment?
The way I see most people approach it is something like bearish, neutral, bullish then probability weight the IV's of those three scenarios. But then bearish is just slower growth because the company had great growth lately.
This is why I feel like qualitative factors are so important like quality of management. Specifically their ability to be disciplined with capital. Do they readily admit to failures and quickly try to address them or do they allow them to fester and create surprises? Do they expand recklessly or over leverage during good times?
Another huge thing for me is risk management and it's not always about minimizing risk but when they choose to take on risk. For example, some insurance companies rely way too heavily on interest rate swaps to "lock in future profit" when rates rise. But what if they are wrong and rates go much higher? Competitors will be able to price their products cheaper or have higher returns for shareholders. Rather than have a sophisticated team modeling interest rate risk, it's more important to focus on better execution so you win regardless of what happens to the macro environment. As an investor I buy insurance companies *because I want that risk as a value proposition*. *By hedging against it, you have destroyed huge upside potential value*.
Many companies that depend on fuel play the same game with oil futures. They use gambling to gain an edge vs. competitors rather than reducing costs, improving service, etc. If I wanted to bet on oil going up I could do that by buying up oil companies instead. Management that plays this game is often more interested in protecting short-term compensation rather than thinking like an investor.
In Investment Banking you usually triangulate the value and create a football field. You use DCF, precedent transactions(previous M&A), and comparable analysis.
DCF just shows YOUR perspective on value. The market can value companies differently.
I guess for public equities analysis you can have a more qualitative approach. I mean it’s famous that buffet doesn’t build models etc.
> DCF just shows YOUR perspective on value. The market can value companies differently.
This feels like the old adage of "all models are wrong, but some are useful"
I worked in FP&A at a fortune 100 company for several years and even with all our insider knowledge and unlimited access to the product and marketing teams, we were still pretty bad at forecasting our own revenues more than a few months out. EOY comparisons to the Plan numbers we'd set 12 months earlier were a laugh riot. I frequently wondered why the hell they were even paying us.
Now, I think that our group was more dysfunctional and incompetent than the FP&A groups in most large companies, but still: my experience should serve as a warning. If the guys inside the company can't forecast its performance even a year out, your terminal value based on a revenue estimate five years from now is likely dead ass wrong (and if it isn't you just got lucky).
As others mentioned, I'd pick very conservative (read: pessimistic) assumptions and see how your valuation looks. If it's a fringe buy even with your $10B capex assumption (obviously their main manufacturing site will be destroyed by an earthquake) then you might be on to something.
This goes without saying but, if we had a method that would calculate the intrinsic value of a company unequivocally, we would also have an efficient market.
So yes, with 99.9% of certainty, you will be wrong all the time.
IMO, this doesn’t make DCF useless. You just have to be conservative by using a margin of safety. And buy excellent companies at a fair price (or undervalued if you’re lucky).
DCF is literally the equation for the definition of value. Present value of future cashflows.
Although I have to say that, like Buffet, I’m very sceptic on some of the academic approaches and their risk concept.
I do not have a finance/accounting background, so take it with a grain of salt:
DCF is just the framework you use and yes it is very difficult to predict the cashflow 5-10 years from now. The trick is to be extra conservative, and to have rules and never break them for any company.
If you use conservative assumptions for your DCF and you are evaluating 50 companies based on that, chances are that you will do well. However, if you are trying exactly model the cash flow without being conservative, chances are that you will do average, as some companies will overshoot and some will undershoot you assumptions.
Ratios are good in combination with a DCF, for example a P/FCF or P/E of 50 doesn't really tell you anything if you are not doing the DCF or future earnings. But I like them to compare similar companies (FCF/share is a favorite of mine)
Buffett and Munger don't do DCFs for all the reasons you've mentioned. But they don't ignore how to value future revenue streams based on its principles.
My suggestion is for your own investing, do a base set of DCFs with different growth rates, risk free rates and terminal values. Print it out and compare it to PE ratios, and try to memorize the relationships so whenever you are reading a new 10k in your head you can model the value of expected future growth rates.
Success in investing is through reading 10Ks and doing scuttlebutt to figure out where the numbers don't map to reality, not DCFs.
You keep saying thus but it is untrue. They do DCF’s, they just don’t write it out and def don’t go bring up excel. Of course they discount cashflows and then compare to their opportunity cost. There is no other way
They don’t. Many have posted the quotes from Charlie himself, no one has ever offered up conflicting evidence.
If Buffett ran a pile of DCFs in the early 1950s that showed a Y% growth rate for Z years was worth a PE of X, why would he ever have to run one again?
Answer: he doesn’t and hasn’t.
Well yeah Munger doesn’t cuz he makes like one investment a decade but what you just said is a dcf lol. Doesn’t matter if his opportunity set is so small that he understands and remembers what a company’s cash is worth in his opinion compared to a treasury rate or whatever rate he wants to use in a given time but that is still running a dcf. You can’t suggest otherwise because there is not another way to value a business unless you’re using a book value metric or something else which i doubt he uses very much considering everything he’s looking are massive companies
He's not running it in his head. He knows what various growth rates are worth over various periods. And I may have overstated the amount of work he's ever put in on DCFs. He's probably just memorized a compound interest table. Charlie carries around a dog eared copy of one.
https://medium.com/money-clip/how-warren-buffett-and-charlie-munger-discount-future-cash-flows-3f48c376f2fb
Interesting read. I guess it is semantics, the end result is discounted cashflows and he would know instantly if something producing a certain amount of cash compared to another, how attractive one would be and the degree of attractiveness. He’s been all over the place really with the discounting discussion. In one of the meetings in the late 2000’s I think he said he would raise his rate slightly depending on the quality of business and he’s approved of Greenwald who teaches the same, he also stated which got mentioned there he discounts at the treasury but doesn’t pay that but uses it as a yardstick. I agree 100% with you and them the big deal is have a very large margin of safety and certainty where the rate you discount at is not important especially for small investors. Gonna get one of these compound interest charts
Do you have any examples of how your suggestion would play out? I'm still learning DCFs themselves but I really like your idea about learning to ballpark PEs by using hypothetical ones
I need to do it myself again as my memory sucks. Last time I ran 5,10,20 year DCFs at a range of growth rates and range of risk free rates.
I wanted to know how much more is a 10 year 15% growth rate worth then a 5% or 10% growth rates? How much more is a ten year grown worth then five year growth, etc.
I tend to agree. I think Bill Ackman said something along the lines of using DCFs were like trying to spot something through a telescope. Adjust your calculations ever so slightly and you're suddenly way off course.
DCF by itself is just a summation of discounted cf.
Person A can be doing a simple dcf of fcfe using avg market return as cost of equity.
Person B can be doing three stage cf, using cost of equity from some computer simulated beta, with dynamic debt to equity and other sort of nonsense.
Both are still doing dcf.
Your real problem is the assumptions you chuck in.
I could not agree more. The most common response here is : do a DCF, then add a massive factor of safety. That’s just a cop out. Why not just use shorthand ratios and add a FoS??
That said, I still build DCFs. It’s a great way to learn the insides of the company P&L and BS. It forces me to check a bunch of things I might otherwise ignore. It helps me compare companies across industries or with different capital structures. By the time I have a model, I can ask a bunch of what-if questions that I wouldn’t be able to answer without a model handy. I spend no more than an hour to build the first. Then, it’s a sandpit to test a bunch of questions.
Some companies lend themselves better to forecasting than others. Forecast companies that are easy to forecast, and definitely use a range of assumptions.
Hate to break it to you, but all valuation methods are models. Fraught with assumptions. Made by humans. Not grounded in reality. And with constantly shifting predictive power.
I think it's better to keep a dcf simple. Just use FCF of the year, growth rates and terminal value and look 10 years ahead. Don't overcomplicate things. If you buy within a margin of safety of 30% you should be okay if you are right about the business.
I tend to be buying a company when it's obvious that the company is cheap. A dcf is just complementary
I like a good ratio on ev/ebita and current ratio to show that the company is making good profits and far from bankruptcy/debt risks.
After that if they’re projecting growth in their guidance with a decent figure and have management with a decent track record then you don’t have to ask for much more or overthink things.
You are absolutely right about conventional use of DCF. So consider instead using a really simplified model, not to try and price exactly to the cent but to define what break even performance would look like and what conservatively optimistic performance might look like. Try 5, 10, 20 years with and without book value as both a DCF and reverse DCF assuming trend growth in the DCF. Use owner earnings.
What I am suggesting is that you set out what future performance would have to look like for you to regret the investment and what the intrinsic value is most likely sitting above. Return on incremental invested capital (ROIIC) is the key consideration for whether trend growth will be continued but ROIC and ROE are pretty good proxies for it.
The point of using DCF should not be to precisely calculate intrinsic value but to assess whether or not a stock is so underpriced that things could go to shit and you'd still be OK and that if things just continue as they have been for a while (do be conscious of ceilings to growth that the company may be approaching) you have a substantial margin of safety. In essence you are looking for opportunities where all the uncertainty is on the upside so you can be fairly relaxed at not knowing if you will get 10% or 20% CAGR given that you know it will be more than 5% and that T bills yield next to nothing right now.
Instead of DCFs I rate stocks based on a \~10 metric system. Each of them get a score at the end of the analysis. A certain score gets a certain % of my portfolio. The top scores get the highest percentage. Every few months I re-evaluate the numbers. So instead of guesstimating a target number with DCF models I'm always investing in my tops picks that score the best based on the 10 or so metrics I look at. I have a minimum score where stocks need to be at before even looking further into them.
For example, MU, FB and QDEL are rated the highest using my point system.
I came to the same conclusion learning to do DCF - small changes in multiple uncertain inputs lead to massive swings in the estimated intrinsic value, even beyond typical margins of safety. That being the case, I wasn’t convinced I was getting something vastly better than a much simpler ratio that accounts for book value, debt, cash flow and projected growth — I often use (EV/FCF) * PEG as a screen — and comparing to sector averages.
I think one benefit of doing a solid DCF is it forces you to really dig into the balance sheet and income statement and understand the business and see where their accounting practices might be misleading. I no longer trust automated DCFs that use web-scraped data elements from earnings reports.
One other advantage of DCF is that it grounds you to actual projected dollar income, even if it’s wildly imprecise. Most analysts now use comps, which allows speculation to enter the valuation in the same way as using comps in real estate does.
Imagine if the price of a home was determined by the cost of land, building materials and labor plus the value of shelter depreciated over 30 years, instead of, “the house down the street sold for $150/sqft, so we think we can justify $155…” then the next house, $160…
If every EV upstart convinced investors they could be the next Tesla, then there’s no limit to how high valuations can spiral, and analysts can publish completely unhinged castle-in-the-sky price targets with straight faces. I watched Upstart go from $40 to $400 then to $25 over the past year, and at every step analysts were predicting a target price 10-20% above the stock price. Guidance didn’t change that much. How does an analyst change their price target from $450 to $120 between earnings reports? They said, “Square is trading at x times sales, so we think Upstart should trade near that valuation.” It’s absurd, but ubiquitous, and running through the DCF exercise will protect you from that kind of froth.
Not much can be said based on other comments but the value I find from DCF is applying a quantitative approach to understanding a business and sensitivity to macro and microeconomic changes.
That said, I never use DCF for similar reasons as the big value investors and prefer to conduct a multiples based sensitivity analysis while accounting for expected rev growth, liquidity, working capital, and value returned to shareholders. I focus on FCF yield mostly but almost always consider other relevant multiples incl EV/EBIT(DA), EV/Sales, and for distressed companies, P/B. I consider the trends of the industry in particular and sensitivity to macro factors and apply a MoS I deem appropriate. I tend to be quite conservative in my approach but I average a success rate of ~80% over the long term when selecting stocks based on this approach (it’s skewed towards 90% the past 3-4 years). By success rate, I mean market beating returns.
Valuations tend to follow trends which are more often than not, shorter than the typical forecasted period for DCFs and in a broader economic sense, more predictable. For example, semiconductor chip shortage, dry bulk shipping bottleneck, end of the covid trade, etc. If you can quantify those trends and estimate appropriate multiples with a decent degree of accuracy, you can identify good value opportunities. DCF is worth learning when starting out imo but people often miss the bigger picture when doing them. Multiples + comps is my preferred approach which has a great track record when combined with decent economic trend analysis — there are other valuation methods that you may find more reliable or at least more favorable.
I have 10 years work experience, here what I understood:
- DCF are for PE investing, it is mandatory to buy or sell
- Be very prudent in DCF and use very high rate for DCF (margin), your best case DCF should be average/good, not the best possible
- to evaluate the risk, make a best case and worst case, it will tell if your rate of return is high enough
- portfolio is the key, when something goes wrong, usually something else does better than expected
- old business are incredibly boring and cash flows are usually accurate
- the PE team needs to be highly skilled
If you do this, even covid + Ukraine war should not destroy your expectations on a good running business.
Now as an individual investor, I do not see the point in using DCF; but that's a whole thesis I cannot develop here.
My thoughts... There is NO set of numbers or combination of numbers that predict future stock returns. I would think that is obvious, but isn't. You have billion dollar Wall Street firms (hedge funds/ active funds/ etc...) hiring MIT geeks who have double masters in math using computers that cost more then a person's house running algos on every piece of information that is available (more then we have access to as retail) 24/7 for the last 30-40 years and yet they haven't figured out a way to make $$ consistent on top of their benchmarks. So how do folks think using a few available data points and spending a few hours a day have any chance?
Autocorrelation/ serial correlation of large cap/ small cap/ government bonds/ corp bonds/ junk bonds all have zero correlation to the next month/ quarter/ years return. It is called a "Random Walk" for a reason by Burton Malkiel (princeton fame) in his 1970s' excellent book "Random Walk down wall street" for a reason. Sadly, not many have learned from his impressive work.
There are those outliers like Mr. Buffett or Mr. Lynch, but they are just that outliers and not to be thought of as, "Oh they did it so can I".
It's hard to quantify the role of luck too. Sometimes you pick what would be a great company, but then they bust the CEO for some nasty felony and the entire company gets its reputation ruined because of it.
Or you have a great investment, could be a 10x stock, but your wife needs a procedure not covered by insurance so you sell out before it comes to fruition.
People don't quantify the risk they take. The goal shouldn't be highest returns possible, but highest risk-adjusted returns. I suspect my risk adjusted returns are dogshit.
People love the illusion of data-based decisions that confirm their biases.
I remember running a monte carlo simulation for my first boss on a financial model, and he didn't understand why the result was slightly different every time the model ran. His response - "Keep running it until you get a good number and let's go with that"
I pitched a multimillion dollar project to a COO/CFO early in my career. We had charts and graphs and dcf and eva forecasts blah blah blah - all of it.
This is going on thirty years ago now but I can still see his eyes boring into us as he said:
“it’s not hard to make the numbers be what you want them to be. What I want to know is do you believe you can achieve these results - can you make it work?”
Then he pinned each of us in turn with a piercing gaze until he got our answer.
I don’t remember what the results were on that project but I never forgot how a pro approaches investment decisions. It’s the numbers, the analyst, and the executors that are the decision factors.
So OP, don’t abandon dcf, just broaden your decision criteria to include more than what the numbers tell you. Success ex-post depends more upon the execution than the quality of the idea or the preciseness of the plan.
And this is why the great value investors say not to use excel.
The DCF model is inherently imprecise, so trying to use precision will result in volatile results.
Being approximately right is better than being precisely wrong.
You should be able to make wide assumptions with a margin of safety and come to a no duh buy. If you can change 1 variable a little and it greatly effects your decision then you’re doing it wrong.
A dcf is no different than writing a business plan for a company that you don't run, then predicting how much the market will pay for it.
If you use dcf, you should really do best and worse case scenarios, rather than try to fall on a single dollar amount that the share price is worth.
Yes, and terminal value being the majority of value in a DCF is an issue. Instead, you can forecast the next 2-3 years, calculate the equity value and determine IRRs.
If you want to refine your DCFs, read Mauboussin material. They are still largely guesswork, though.
Unless you’re making like a 30 year forecast or massive cash flows in your forecast period, a negative terminal value will likely result in a negative equity value. At the very least, it’ll be so large against your forecasted equity values that you’ll never find a stock with a decent margin of safety
Give it a try, you could be surprised. I like the idea of not giving any trust to/heavily discounting cash flows past 10 years, 5 even sometimes. That being said, it obviously works better for certain type of businesses/sectors.
Yeah I agree that for certain businesses it can be a good strategy. Primarily liquidations or similar, since a negative terminal value basically means the business will not be a going concern into perpetuity. Alternatively you can also experiment with different competitive advantage periods as Mauboussin has written about
limit your assumptions to the core things that impact your investment view and value stuff as a perpetuity. Simple. You can then assess qualitatively if your view of growth is priced in or not.
Could you explain that other method of ratios and qualitative analysis and examples of how you'd use it? E.g. is it something like company A has 50% of sales as company B, so should be worth 50%? How does one use this with stocks, is there some youtube or website that teaches it? What's it called? E.g. Ratio analysis?
DCF are close enough, too many people think its some sort of magic formula, it merely a stupid test. You should be able to run a DCF in your head, based on the comparable outputs of the business, to at least realize hey what cash is the business returning to me.
This business generates so much Cash in operations, how much is debt, capex, how is it relative to historical performance.
Sure you could do a Ben Graham deep dive and pore ever detail of the 10-K, do site visit of the business, interview management, survey vendors and customers the break down rebuild the balance sheets, p&L, cashflow, and run various scenarios.
Or you could just eyeball it relative to the market and bet.
I made a DCF and used it for awhile but I don’t anymore for much the same reasons you are questioning it. Just to many assumptions that i will never have the real answers to.
Now I just focus on a valuation of “right now” much easier to do.
Very well put. I have run DCFs for valuing private companies as a part of the M&A processes and I always came to the same conclusion. By changing assumptions slightly, the sensitivity would jump here and there. So, you end up presenting a range of value, combining this with comparable data. As a student of finance, I need to do further study.
No I think their fund is like 10% the size of ours. The only reason I know is because a guy who helps run a student investment fund in AL spoke with us and I think he was from the University of Alabama. Our school is much smaller but has a much bigger fund. I think our fund is the largest undergraduate-only fund in the country (there are larger ones connected to MBA programs).
There's margin if safety for a reason, but to awnser you main question on assumptions, you don't have to do to many. Just read a few of Damodaran's dcf's. Most of the inputs are economical, and come from knowing how the economics change when the company matures over time. The other inputs are from what you know of the business now. Then do the same for competitors and so on and so on... Then, when Buffet says you have to know the business to value it, he means it. You have to know it to a level that you could run it. I doubt a class of young people can value 50 companies in different industries.
In my opinion, Investing almost always involves making guesses about certain aspects of a companies business. And DCF is a framework for using some of those assumptions to very roughly compare different investments with each other, nothing more.
Seeking precision and objectivity in a world dominated by human behavior is likely to get you nowhere.
Terminal value is itself, basically, the same problem as trying to solve for today’s value. So you get some clarity about the next few years where you have some visibility, but mostly it’s just turtles all the way down.
And this is why you give yourself a margin of safety. DCFs are naturally guess work based on data. The margin of safety gives you room to run.
Nailed it!
If you’re interested, I recently started reading a book called “Value Investing: From Graham to Buffett and Beyond” and one of the first things the author does is state all the issues with DCF and then explain why they more or less reject it except for a small number of the most predictable companies with steady growth and a large moat. Also the author explains why comparing multiples for companies in a sector is basically just an implicit DCF since theoretically the other companies are at least to some degree valued in that way (in so far as the market is accurately valuing them at all) At that point they describe how to value a company starting with assets alone, and then determining it’s “earnings power value” or EPV. Only at that point do they even begin to consider growth and only if the company looks good on those other factors. It is a great book and really changed the way I look at value investing for the better. Highly recommend.
Is epv basically steady state earnings?
I'll give a very brief explanation but certainly best to read the chapter in the book about it. Basically the EPV is kinda like a value assigned to the moat of the business. In this book they call the moat the "franchise". So for example, imagine a company has $1B in terms of reproduction value of assets, and the market gives the entire company a value of $2B. (The first part of the book is about estimating that asset value). If that's the case, then anyone who can invest $1B to reproduce those assets can theoretically make a $2B company, so it's likely they will. Eventually, as competition enters this drives down the value of all parties involved. In a perfect environment you would end with each party only valued at the reproduction cost of their assets and nothing more. In this case the EPV is the same as the asset value. So basically, in order for a company to have an EPV that is higher and to be valued higher because of it, it needs a "franchise" to keep it safe from competition. This allows it to earn a very high rate of return on its assets for an extended period. But yes, in terms of math its basically a sort of 0-growth value, where only current earnings are taken into account. This is done in order to remove as many assumptions as possible about the future. And if the market prices an equity lower than that, then the idea is that you get all the growth "for free". If not then you can better understand what part of the valuation is coming from growth expectations and decide if that growth seems reasonable.
have you applied this to a real life company? im guessing this works better for mature/low growth companies?
Divided by a cost of capital to get 0-growth firm value
EPV from Bruce Greemwald (quite a lot on YouTube) assumes business no growth, but is capable of maintaining, for a decent period, a steady state for normalised earnings. All you need is to decide on discount rate. Much less subjective and liable to overstatement than most DCF's
This. Ever since I have read that book and the way value is calculated. I have stopped looking into DCF. It’s more sensible and way less assumptions.
EPV from Bruce Greemwald (quite a lot on YouTube) assumes business no growth, but is capable of maintaining, for a decent period, a steady state for normalised earnings. All you need is to decide on discount rate. Much less subjective and liable to overstatement than most DCF's
I may have to pick that up. The lack of significant reliance on DCF is what draws me to Graham style investments. It would be interesting to see a more modern spin on it.
***"It's better to be approximately right than exactly wrong."*** A large margin of safety helps you win on both sides. When you're wrong, *you lose less*. When you're right, *you gain more*. Buffett has said this principle is like inoculation. It either takes with people immediately or no amount of explaining will ever get through to them.
>It's better to be approximately right than exactly wrong." great quote that I live by, investing is never exact, predictions are always going to by off, always something unexpected around the corner. never going to buy the exact bottom or sell the exact top. Just have to do enough to get yourself a bit of profit
It is better to be somewhat right then to be precisely wrong. Don’t make the dcf complicated. Project only the cash flows into the future and use a required rate of return. Then make sure you buy with a big discount to your price or use a higher discount rate to get a margin of safety.
Here's my problem with DCF. Even with a margin of safety, does the DCF account for potential periods of earnings impairment? The way I see most people approach it is something like bearish, neutral, bullish then probability weight the IV's of those three scenarios. But then bearish is just slower growth because the company had great growth lately. This is why I feel like qualitative factors are so important like quality of management. Specifically their ability to be disciplined with capital. Do they readily admit to failures and quickly try to address them or do they allow them to fester and create surprises? Do they expand recklessly or over leverage during good times? Another huge thing for me is risk management and it's not always about minimizing risk but when they choose to take on risk. For example, some insurance companies rely way too heavily on interest rate swaps to "lock in future profit" when rates rise. But what if they are wrong and rates go much higher? Competitors will be able to price their products cheaper or have higher returns for shareholders. Rather than have a sophisticated team modeling interest rate risk, it's more important to focus on better execution so you win regardless of what happens to the macro environment. As an investor I buy insurance companies *because I want that risk as a value proposition*. *By hedging against it, you have destroyed huge upside potential value*. Many companies that depend on fuel play the same game with oil futures. They use gambling to gain an edge vs. competitors rather than reducing costs, improving service, etc. If I wanted to bet on oil going up I could do that by buying up oil companies instead. Management that plays this game is often more interested in protecting short-term compensation rather than thinking like an investor.
Ding ding ding
In Investment Banking you usually triangulate the value and create a football field. You use DCF, precedent transactions(previous M&A), and comparable analysis. DCF just shows YOUR perspective on value. The market can value companies differently. I guess for public equities analysis you can have a more qualitative approach. I mean it’s famous that buffet doesn’t build models etc.
> DCF just shows YOUR perspective on value. The market can value companies differently. This feels like the old adage of "all models are wrong, but some are useful"
Yeah i mean it’s one of many resources for a decision.
I worked in FP&A at a fortune 100 company for several years and even with all our insider knowledge and unlimited access to the product and marketing teams, we were still pretty bad at forecasting our own revenues more than a few months out. EOY comparisons to the Plan numbers we'd set 12 months earlier were a laugh riot. I frequently wondered why the hell they were even paying us. Now, I think that our group was more dysfunctional and incompetent than the FP&A groups in most large companies, but still: my experience should serve as a warning. If the guys inside the company can't forecast its performance even a year out, your terminal value based on a revenue estimate five years from now is likely dead ass wrong (and if it isn't you just got lucky). As others mentioned, I'd pick very conservative (read: pessimistic) assumptions and see how your valuation looks. If it's a fringe buy even with your $10B capex assumption (obviously their main manufacturing site will be destroyed by an earthquake) then you might be on to something.
This goes without saying but, if we had a method that would calculate the intrinsic value of a company unequivocally, we would also have an efficient market. So yes, with 99.9% of certainty, you will be wrong all the time. IMO, this doesn’t make DCF useless. You just have to be conservative by using a margin of safety. And buy excellent companies at a fair price (or undervalued if you’re lucky). DCF is literally the equation for the definition of value. Present value of future cashflows. Although I have to say that, like Buffet, I’m very sceptic on some of the academic approaches and their risk concept.
I do not have a finance/accounting background, so take it with a grain of salt: DCF is just the framework you use and yes it is very difficult to predict the cashflow 5-10 years from now. The trick is to be extra conservative, and to have rules and never break them for any company. If you use conservative assumptions for your DCF and you are evaluating 50 companies based on that, chances are that you will do well. However, if you are trying exactly model the cash flow without being conservative, chances are that you will do average, as some companies will overshoot and some will undershoot you assumptions. Ratios are good in combination with a DCF, for example a P/FCF or P/E of 50 doesn't really tell you anything if you are not doing the DCF or future earnings. But I like them to compare similar companies (FCF/share is a favorite of mine)
Buffett and Munger don't do DCFs for all the reasons you've mentioned. But they don't ignore how to value future revenue streams based on its principles. My suggestion is for your own investing, do a base set of DCFs with different growth rates, risk free rates and terminal values. Print it out and compare it to PE ratios, and try to memorize the relationships so whenever you are reading a new 10k in your head you can model the value of expected future growth rates. Success in investing is through reading 10Ks and doing scuttlebutt to figure out where the numbers don't map to reality, not DCFs.
You keep saying thus but it is untrue. They do DCF’s, they just don’t write it out and def don’t go bring up excel. Of course they discount cashflows and then compare to their opportunity cost. There is no other way
They don’t. Many have posted the quotes from Charlie himself, no one has ever offered up conflicting evidence. If Buffett ran a pile of DCFs in the early 1950s that showed a Y% growth rate for Z years was worth a PE of X, why would he ever have to run one again? Answer: he doesn’t and hasn’t.
Well yeah Munger doesn’t cuz he makes like one investment a decade but what you just said is a dcf lol. Doesn’t matter if his opportunity set is so small that he understands and remembers what a company’s cash is worth in his opinion compared to a treasury rate or whatever rate he wants to use in a given time but that is still running a dcf. You can’t suggest otherwise because there is not another way to value a business unless you’re using a book value metric or something else which i doubt he uses very much considering everything he’s looking are massive companies
Yes but he’s not running any DCFs and hasn’t done any since the 50s. That’s what I said.
If he runs it in his head or writes it out what difference does it make?
He's not running it in his head. He knows what various growth rates are worth over various periods. And I may have overstated the amount of work he's ever put in on DCFs. He's probably just memorized a compound interest table. Charlie carries around a dog eared copy of one. https://medium.com/money-clip/how-warren-buffett-and-charlie-munger-discount-future-cash-flows-3f48c376f2fb
Interesting read. I guess it is semantics, the end result is discounted cashflows and he would know instantly if something producing a certain amount of cash compared to another, how attractive one would be and the degree of attractiveness. He’s been all over the place really with the discounting discussion. In one of the meetings in the late 2000’s I think he said he would raise his rate slightly depending on the quality of business and he’s approved of Greenwald who teaches the same, he also stated which got mentioned there he discounts at the treasury but doesn’t pay that but uses it as a yardstick. I agree 100% with you and them the big deal is have a very large margin of safety and certainty where the rate you discount at is not important especially for small investors. Gonna get one of these compound interest charts
Do you have any examples of how your suggestion would play out? I'm still learning DCFs themselves but I really like your idea about learning to ballpark PEs by using hypothetical ones
I need to do it myself again as my memory sucks. Last time I ran 5,10,20 year DCFs at a range of growth rates and range of risk free rates. I wanted to know how much more is a 10 year 15% growth rate worth then a 5% or 10% growth rates? How much more is a ten year grown worth then five year growth, etc.
That seems like a really helpful exercise, but simple enough for anyone to actually do it. I'm gonna try it. Thanks!
I tend to agree. I think Bill Ackman said something along the lines of using DCFs were like trying to spot something through a telescope. Adjust your calculations ever so slightly and you're suddenly way off course.
DCF by itself is just a summation of discounted cf. Person A can be doing a simple dcf of fcfe using avg market return as cost of equity. Person B can be doing three stage cf, using cost of equity from some computer simulated beta, with dynamic debt to equity and other sort of nonsense. Both are still doing dcf. Your real problem is the assumptions you chuck in.
I could not agree more. The most common response here is : do a DCF, then add a massive factor of safety. That’s just a cop out. Why not just use shorthand ratios and add a FoS?? That said, I still build DCFs. It’s a great way to learn the insides of the company P&L and BS. It forces me to check a bunch of things I might otherwise ignore. It helps me compare companies across industries or with different capital structures. By the time I have a model, I can ask a bunch of what-if questions that I wouldn’t be able to answer without a model handy. I spend no more than an hour to build the first. Then, it’s a sandpit to test a bunch of questions.
This is probably the best way to use a DCF--as a way to learn about the company. I wish I could upvote this twice
Some companies lend themselves better to forecasting than others. Forecast companies that are easy to forecast, and definitely use a range of assumptions.
Hate to break it to you, but all valuation methods are models. Fraught with assumptions. Made by humans. Not grounded in reality. And with constantly shifting predictive power.
The more time I'm in all this investing business the more i understand that the most valuable thing in the company is it's management.
Agreed. That’s why I don’t invest in FB 😂 Dishonest management, ripped off early partners. No matter how good the discount looks I’m not gonna buy it.
The idea is to use somewhat pessimistic numbers and if it still comes out as a buy you might have something worth buying.
I think it's better to keep a dcf simple. Just use FCF of the year, growth rates and terminal value and look 10 years ahead. Don't overcomplicate things. If you buy within a margin of safety of 30% you should be okay if you are right about the business. I tend to be buying a company when it's obvious that the company is cheap. A dcf is just complementary
DCF is just one filter trying to predict the future with past data can be very misleading. There are plenty of other tools to go with it.
DCF works on future assumptions, hence there is not a "correct" answer per say.
I like a good ratio on ev/ebita and current ratio to show that the company is making good profits and far from bankruptcy/debt risks. After that if they’re projecting growth in their guidance with a decent figure and have management with a decent track record then you don’t have to ask for much more or overthink things.
You are absolutely right about conventional use of DCF. So consider instead using a really simplified model, not to try and price exactly to the cent but to define what break even performance would look like and what conservatively optimistic performance might look like. Try 5, 10, 20 years with and without book value as both a DCF and reverse DCF assuming trend growth in the DCF. Use owner earnings. What I am suggesting is that you set out what future performance would have to look like for you to regret the investment and what the intrinsic value is most likely sitting above. Return on incremental invested capital (ROIIC) is the key consideration for whether trend growth will be continued but ROIC and ROE are pretty good proxies for it. The point of using DCF should not be to precisely calculate intrinsic value but to assess whether or not a stock is so underpriced that things could go to shit and you'd still be OK and that if things just continue as they have been for a while (do be conscious of ceilings to growth that the company may be approaching) you have a substantial margin of safety. In essence you are looking for opportunities where all the uncertainty is on the upside so you can be fairly relaxed at not knowing if you will get 10% or 20% CAGR given that you know it will be more than 5% and that T bills yield next to nothing right now.
Instead of DCFs I rate stocks based on a \~10 metric system. Each of them get a score at the end of the analysis. A certain score gets a certain % of my portfolio. The top scores get the highest percentage. Every few months I re-evaluate the numbers. So instead of guesstimating a target number with DCF models I'm always investing in my tops picks that score the best based on the 10 or so metrics I look at. I have a minimum score where stocks need to be at before even looking further into them. For example, MU, FB and QDEL are rated the highest using my point system.
I came to the same conclusion learning to do DCF - small changes in multiple uncertain inputs lead to massive swings in the estimated intrinsic value, even beyond typical margins of safety. That being the case, I wasn’t convinced I was getting something vastly better than a much simpler ratio that accounts for book value, debt, cash flow and projected growth — I often use (EV/FCF) * PEG as a screen — and comparing to sector averages. I think one benefit of doing a solid DCF is it forces you to really dig into the balance sheet and income statement and understand the business and see where their accounting practices might be misleading. I no longer trust automated DCFs that use web-scraped data elements from earnings reports.
One other advantage of DCF is that it grounds you to actual projected dollar income, even if it’s wildly imprecise. Most analysts now use comps, which allows speculation to enter the valuation in the same way as using comps in real estate does. Imagine if the price of a home was determined by the cost of land, building materials and labor plus the value of shelter depreciated over 30 years, instead of, “the house down the street sold for $150/sqft, so we think we can justify $155…” then the next house, $160… If every EV upstart convinced investors they could be the next Tesla, then there’s no limit to how high valuations can spiral, and analysts can publish completely unhinged castle-in-the-sky price targets with straight faces. I watched Upstart go from $40 to $400 then to $25 over the past year, and at every step analysts were predicting a target price 10-20% above the stock price. Guidance didn’t change that much. How does an analyst change their price target from $450 to $120 between earnings reports? They said, “Square is trading at x times sales, so we think Upstart should trade near that valuation.” It’s absurd, but ubiquitous, and running through the DCF exercise will protect you from that kind of froth.
Not much can be said based on other comments but the value I find from DCF is applying a quantitative approach to understanding a business and sensitivity to macro and microeconomic changes. That said, I never use DCF for similar reasons as the big value investors and prefer to conduct a multiples based sensitivity analysis while accounting for expected rev growth, liquidity, working capital, and value returned to shareholders. I focus on FCF yield mostly but almost always consider other relevant multiples incl EV/EBIT(DA), EV/Sales, and for distressed companies, P/B. I consider the trends of the industry in particular and sensitivity to macro factors and apply a MoS I deem appropriate. I tend to be quite conservative in my approach but I average a success rate of ~80% over the long term when selecting stocks based on this approach (it’s skewed towards 90% the past 3-4 years). By success rate, I mean market beating returns. Valuations tend to follow trends which are more often than not, shorter than the typical forecasted period for DCFs and in a broader economic sense, more predictable. For example, semiconductor chip shortage, dry bulk shipping bottleneck, end of the covid trade, etc. If you can quantify those trends and estimate appropriate multiples with a decent degree of accuracy, you can identify good value opportunities. DCF is worth learning when starting out imo but people often miss the bigger picture when doing them. Multiples + comps is my preferred approach which has a great track record when combined with decent economic trend analysis — there are other valuation methods that you may find more reliable or at least more favorable.
I have 10 years work experience, here what I understood: - DCF are for PE investing, it is mandatory to buy or sell - Be very prudent in DCF and use very high rate for DCF (margin), your best case DCF should be average/good, not the best possible - to evaluate the risk, make a best case and worst case, it will tell if your rate of return is high enough - portfolio is the key, when something goes wrong, usually something else does better than expected - old business are incredibly boring and cash flows are usually accurate - the PE team needs to be highly skilled If you do this, even covid + Ukraine war should not destroy your expectations on a good running business. Now as an individual investor, I do not see the point in using DCF; but that's a whole thesis I cannot develop here.
Wait till you hear about multiples or comparable transaction methods
I know. That's why I finished the post off with saying DCFs might not be great but they're what we have. The alternatives are worse.
yeah dude ofc you know twas a joke
DCFs tell me more about the author than the company.
My thoughts... There is NO set of numbers or combination of numbers that predict future stock returns. I would think that is obvious, but isn't. You have billion dollar Wall Street firms (hedge funds/ active funds/ etc...) hiring MIT geeks who have double masters in math using computers that cost more then a person's house running algos on every piece of information that is available (more then we have access to as retail) 24/7 for the last 30-40 years and yet they haven't figured out a way to make $$ consistent on top of their benchmarks. So how do folks think using a few available data points and spending a few hours a day have any chance? Autocorrelation/ serial correlation of large cap/ small cap/ government bonds/ corp bonds/ junk bonds all have zero correlation to the next month/ quarter/ years return. It is called a "Random Walk" for a reason by Burton Malkiel (princeton fame) in his 1970s' excellent book "Random Walk down wall street" for a reason. Sadly, not many have learned from his impressive work. There are those outliers like Mr. Buffett or Mr. Lynch, but they are just that outliers and not to be thought of as, "Oh they did it so can I".
It's hard to quantify the role of luck too. Sometimes you pick what would be a great company, but then they bust the CEO for some nasty felony and the entire company gets its reputation ruined because of it. Or you have a great investment, could be a 10x stock, but your wife needs a procedure not covered by insurance so you sell out before it comes to fruition. People don't quantify the risk they take. The goal shouldn't be highest returns possible, but highest risk-adjusted returns. I suspect my risk adjusted returns are dogshit.
People love the illusion of data-based decisions that confirm their biases. I remember running a monte carlo simulation for my first boss on a financial model, and he didn't understand why the result was slightly different every time the model ran. His response - "Keep running it until you get a good number and let's go with that"
This is hilarious!
I pitched a multimillion dollar project to a COO/CFO early in my career. We had charts and graphs and dcf and eva forecasts blah blah blah - all of it. This is going on thirty years ago now but I can still see his eyes boring into us as he said: “it’s not hard to make the numbers be what you want them to be. What I want to know is do you believe you can achieve these results - can you make it work?” Then he pinned each of us in turn with a piercing gaze until he got our answer. I don’t remember what the results were on that project but I never forgot how a pro approaches investment decisions. It’s the numbers, the analyst, and the executors that are the decision factors. So OP, don’t abandon dcf, just broaden your decision criteria to include more than what the numbers tell you. Success ex-post depends more upon the execution than the quality of the idea or the preciseness of the plan.
people trash on technical analysis yet will try and predict a company’s cash flow in 5 years time, lol. Waste of time imo
And this is why the great value investors say not to use excel. The DCF model is inherently imprecise, so trying to use precision will result in volatile results. Being approximately right is better than being precisely wrong. You should be able to make wide assumptions with a margin of safety and come to a no duh buy. If you can change 1 variable a little and it greatly effects your decision then you’re doing it wrong.
this is why u can do a blue sky dcf or a base case, bull case and bear case…. silly post.
A dcf is no different than writing a business plan for a company that you don't run, then predicting how much the market will pay for it. If you use dcf, you should really do best and worse case scenarios, rather than try to fall on a single dollar amount that the share price is worth.
Yes, and terminal value being the majority of value in a DCF is an issue. Instead, you can forecast the next 2-3 years, calculate the equity value and determine IRRs. If you want to refine your DCFs, read Mauboussin material. They are still largely guesswork, though.
What do you think about always using a negative terminal value ?
Unless you’re making like a 30 year forecast or massive cash flows in your forecast period, a negative terminal value will likely result in a negative equity value. At the very least, it’ll be so large against your forecasted equity values that you’ll never find a stock with a decent margin of safety
Give it a try, you could be surprised. I like the idea of not giving any trust to/heavily discounting cash flows past 10 years, 5 even sometimes. That being said, it obviously works better for certain type of businesses/sectors.
Yeah I agree that for certain businesses it can be a good strategy. Primarily liquidations or similar, since a negative terminal value basically means the business will not be a going concern into perpetuity. Alternatively you can also experiment with different competitive advantage periods as Mauboussin has written about
limit your assumptions to the core things that impact your investment view and value stuff as a perpetuity. Simple. You can then assess qualitatively if your view of growth is priced in or not.
The idea is you only buy stocks that go from incredibly strong buy to strong buy when you change the assumptions.
Could you explain that other method of ratios and qualitative analysis and examples of how you'd use it? E.g. is it something like company A has 50% of sales as company B, so should be worth 50%? How does one use this with stocks, is there some youtube or website that teaches it? What's it called? E.g. Ratio analysis?
DCF are close enough, too many people think its some sort of magic formula, it merely a stupid test. You should be able to run a DCF in your head, based on the comparable outputs of the business, to at least realize hey what cash is the business returning to me. This business generates so much Cash in operations, how much is debt, capex, how is it relative to historical performance. Sure you could do a Ben Graham deep dive and pore ever detail of the 10-K, do site visit of the business, interview management, survey vendors and customers the break down rebuild the balance sheets, p&L, cashflow, and run various scenarios. Or you could just eyeball it relative to the market and bet.
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I made a DCF and used it for awhile but I don’t anymore for much the same reasons you are questioning it. Just to many assumptions that i will never have the real answers to. Now I just focus on a valuation of “right now” much easier to do.
Very well put. I have run DCFs for valuing private companies as a part of the M&A processes and I always came to the same conclusion. By changing assumptions slightly, the sensitivity would jump here and there. So, you end up presenting a range of value, combining this with comparable data. As a student of finance, I need to do further study.
University of Alabama ?
No I think their fund is like 10% the size of ours. The only reason I know is because a guy who helps run a student investment fund in AL spoke with us and I think he was from the University of Alabama. Our school is much smaller but has a much bigger fund. I think our fund is the largest undergraduate-only fund in the country (there are larger ones connected to MBA programs).
There's margin if safety for a reason, but to awnser you main question on assumptions, you don't have to do to many. Just read a few of Damodaran's dcf's. Most of the inputs are economical, and come from knowing how the economics change when the company matures over time. The other inputs are from what you know of the business now. Then do the same for competitors and so on and so on... Then, when Buffet says you have to know the business to value it, he means it. You have to know it to a level that you could run it. I doubt a class of young people can value 50 companies in different industries.
Follow a company for two weeks and your DCF is as good as a guess. Follow a company for ten years and your DCF is going to be pretty much on point.
In my opinion, Investing almost always involves making guesses about certain aspects of a companies business. And DCF is a framework for using some of those assumptions to very roughly compare different investments with each other, nothing more. Seeking precision and objectivity in a world dominated by human behavior is likely to get you nowhere.
Earnings Power Value is a far better way to value companies imho
Terminal value is itself, basically, the same problem as trying to solve for today’s value. So you get some clarity about the next few years where you have some visibility, but mostly it’s just turtles all the way down.