Saturday, July 15, 2006

On Discounted Cash Flow Valuation

If we would have been able to reduce the stock valuation to a set of mathematical equations then equity investing wouldn’t have been fun. While I understand the utility of following a systematic approach to valuation, I give very little weightage(approx. 2.5%) to the results of my DCF models in my decision making process. The reason for that is simple. The process required so many assumptions that the probability of being right is very small. It is, however, important to do this exercise because it makes you aware of the risks you are taking and it can give you some clues about the upside.

I generally prefer doing sensitivity analysis on the results of these models. For example if valuation resulting from a set of assumptions is X then I would like to see how this changes if the variables change. For example what if the growth tapers off? What if the interest rates rise? This gives me some idea of the margin of safety I have, while making the investment decision.

Each long term investor must understand that at the bottom of it, he is a businessman. You may be owning smalls parts of many businesses but that doesn’t change the essential nature of the argument. When a businessman takes a decision, say to expand capacity, he would do rough calculation on the expected returns. He would analyze the output price levels which would be needed to make the breakeven. He would check the investments required, fixed costs, running costs to make an educated guess about profitability of the project. He would do an analysis of competitive advantages and disadvantages. He would analyze the market to see if there is room for expanded capacity. If the plan looks fine on paper, he would check if he has resources, expertise and capital to execute the plan. Finally he would think about fall back plans, exit options in case the things don’t go as planned.

To me it would look pretty odd to see a businessman basing his investment decision solely on the output of discounted cash flow valuation models. If this argument is correct then the utility of DCF model to for long term investors should not be overrated.

There is a difference in analyzing the expected returns from a mature business and analyzing the expected returns from a new project. The mature businesses tend to be more predictable but not predictable enough to e reduced to a set of mathematical equations.

La Warren Buffett

1 comment:


Low market cap is the only true measurement of an unervalued stock.