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DCF Model


cmattporter
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I would read McKinsey's book on valuation to help understand the value drivers, and recognize that a model is only as good as the assumptions that go into it. Better to build a series of outcomes under different scenarios, assume some probabilities for those scenarios, and compare that to the market price. Early in my DCF days I spent way too much time building a complex model subject to a litany of input assumptions, only to realize later that more time could be better spent familiarizing yourself with the company, its industry, and the consensus/variant views in the market.

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my rule is, if i have to use some formula or complicated model for calculating this, it is not a good investment.

 

+1

 

People use numbers to give them a sense of security or confidence in their thoughts, a good investment can be described in a few paragraphs, that's it.

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I would read McKinsey's book on valuation to help understand the value drivers, and recognize that a model is only as good as the assumptions that go into it.

 

I think McKinsey's book (Valuation: Measuring and Managing the Value of Companies) is the most in-depth book on the subject. You should be able to get by with an older version as well if you want to save a few bucks. There weren't many changes between the 2nd and 4th editions, for instance.

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I would also recommend just playing around with the numbers. See what kind of FCF you get with certain return on capital and growth %'s. What kind of PE multiple fits with what growth (or shrinking) numbers and risk. For example, a multiple of 7-8x can be a value trap, but a multiple of 10x can be an amazing investment with decent growth prospects and good return on capital and moat.

 

After  a while this becomes intuitive. That is where you want to be. Screw the models. Best way to do this is looking at a lot of businesses and putting all the numbers in excel. I get a decent picture in my head of all the numbers that way.

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I worked in investment banking for a few years and learned how to build pretty detailed financial models, I also learned pretty quickly how useless models are as an investor. There are too many variables that need to be forecasted to make a DCF effective; add that to the fact that in most cases most of the value comes from your terminal value assumptions and what you get is a mechanism to spit out whatever value you want.

 

Having said all of that, I'm relatively new to taking investing seriously and have done a lot of reading. Almost everything on value investing suggests forecasting is useless. I struggled with this idea because in the absence of forecasting, I wasn't really sure how I can measure intrinsic value, which is required to measure your margin of safety. I than came across Bruce Greenwald's from Graham to Buffet book and he presents some more reliable ways to measure value: replacement value and earnings power value. Obviously like all valuation models these have their flaws but they seem less flawed than DCFs so maybe take a look at that as well. I would also be interested to learn how most other folks on the forum measure their margin of safety because there are a lot of really smart people here.

 

Apologies for the digression, to answer your original question, in addition to the McKinsey book, I would also check out the Scoopbooks Series on Investment Banking. They have a good book that goes through DCFs and is a bit more practical than theoretical.

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You are correct abut a bond but the number of unknown variables is relatively small (discount rate and terminal value if distressed) vs. many in a DCF such as growth rates, margins, taxes, working capital, cap-ex and terminal cash flows and capitalization rates (multiples).  I value companies for a living and like the previous poster said you get just about anything out of a DCF.  Even when you benchmark the assumptions, you will still develop a large range due so many factors that can change not to mention the factors out of the company's control that effect value.  Some times we will use a capitalization of cash flows to reduce the complexity. 

 

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After  a while this becomes intuitive. That is where you want to be.

 

If you are relying on a DCF model, you are trying to substitute #'s for experience & confidence. Walk away.

Intuitive means you think first. #'s just confirm/refute if it makes sense, & you're in the right place.

If you cant explain how/why the investment should work, in < 5 short paragraphs; walk away.

 

SD

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I appreciate all of your input. Simplicity and anti-formula belief is a notion I stand by. I will say the DCF model came up in a interview with Buffett at some college forum. The student asked for a way to find intrinsic value quantitatively rather than qualitatively and he responded with John William Burr's "The Theory of Investment Value" DCF approach. I've made DCF models in school (layman's version) and although they do require a lot of assumptions, wouldn't anyone agree they could be of use to the expert? (which I'm not)

 

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I guess it depends upon what you want to do.  If you want to win a court case, provide evidence to an auditor in a financial reporting analysis or provide an analysis to the IRS then it is useful.  You do not need a DCF analysis to identify an undervalued stock as there are easier ways to this via multiples.

 

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I agree that JBW DCF is partly correct to put value of business - CF now until kingdom comes discounted back.. (he put in dividends if memory serves me well)..

 

But the ingrediants that are put in the model is so flawed IMO that it will propbly cause you more damage than good.. some time ago, I simplified the process and created a "mental map" learning all discount rates and growth rates with a fixed terminal value with CF pinned at 1US dollar, that way I got a multiple on every CF out there... so for example if I had a company that generated x with y growth I could use my mental map that was fixed to 1 dollar and come up with a multiple and then multipy it with the companys CF.. I checked my map with analysis out there covering these comps and everytime came very close to their estimation on value... guess how many times it hit that valuation within time frame predicted.?!?  Not once..

 

Second, the discount rate in the model is irrational.. WACC is irrational.. CAPM is irrational... I once looked at an DCF from an analyst with a discout rate lower than the interest on their bond.. I asked why, he pointed at his computer..  In my view, no equity holder would agree to be compensated less with a bigger risk attached than the companys bond holders higher up in the capital structure... hence the value of the company should be much lower.. Also, many confuse discount with risk.. raising the discount rate as some sort of protection against miscalculations in the DCF... serving as MoS..will not help you produce above average results IMO...

 

DCF is linear model... Has anyone ever seen a published model that goes from x down to zero over the years..? me neither.. most of the times, its just straight line upwards.. But ask yourself this question, if you go into a shop applying that model buying 1 can on coca cola.. it will cost you x, but if you next day want to buy 1 million cans of coca cola, you would prob get a discount and the model wont work anymore, i guess I try to say that a business is not linear and cant be quantified.. so its very subjective and best way is to get as much knowledge about it as possible to quantify the value..

 

I could go on and on but will stop here.. sorry for a long reply...

 

Cheers!

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I guess it depends upon what you want to do.  If you want to win a court case, provide evidence to an auditor in a financial reporting analysis or provide an analysis to the IRS then it is useful.  You do not need a DCF analysis to identify an undervalued stock as there are easier ways to this via multiples.

 

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I'd say: it depends. Often there are easier ways, but sometimes a DCF analysis can be very helpful. Take Awilco for example: it has a limited life so you don't have the problem that the far future is a very big part of the total value and at the same time a simple multiple such as the current yield isn't appropriate because the fleet has a limited life (and it doesn't account for periodic maintenance costs).

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I would also be interested to learn how most other folks on the forum measure their margin of safety.

 

We see ‘value’ primarily as a function of marketability, sentiment, & liquidity; other than as a basic screen, CF generation is pretty far down the list. Very little of this, is something that XYZ coy actually controls. We see the cost as what we paid, less any capital recovery to date.

 

MOS may also not be readily extractable. The small, private, partnership of professionals with a dominant share in a great niche business – that trades at a 40% liquidity discount; if/when a buyer can be found. Extraction is by working for the business & taking annual dividends, not trading.

 

MOS is not static. To reduce your cost base you must replace the market maker during liquidity events. But to work for you, you also had to initiate your position at/near the bottom of the business cycle. If value & cost base are both falling simultaneously - there may be little difference.

 

Corrosive risk measurement. Buy 10,000 XYZ for $1; sell 5,000 XYZ for $2 to recover the 10K investment, & retain 5,000 XYZ worth 10K. MOS remains 10K, but how you view it - is now radically different; ROI is no longer 100% - it is infinity.

 

Realized MOS, is expressed as a rising fixed income position - if capital recovery is reinvested in risk free treasuries. That initial 10K in 100% XYZ risk , becomes 10K in 50% XYZ risk (10K XYZ value + 10K in treasuries) ….. or close to ZERO risk if you hold & compound over an extended period (Coca-Cola)

 

Commit that pool of treasures to a limited liability insurance UW group - & you have a Berkshire or FFH.

 

SD

 

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I found comments by Alice Schroeder to be very insightful on this subject.  She is the one person who has had full access to all of Buffett's files containing years of notes and research.  If I remember correctly, she said she never saw one instance where Buffett actually went through a DCF exercise.  In a speech, she said basically all Buffett looks for is investments where the chance of losing money is near zero.  Then he wants a 15% return on day one. 

 

Here's the speech, which is one of the best, in my view, on how Buffett thinks (start watching at about the 20 min mark):

 

I think others have mentioned it in this thread, but I've heard Buffett explicitly state something to the effect of, "The numbers should jump out at you.  If you have to do anything beyond simple arithmetic to figure it out, walk away."

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  • 3 years later...

For those of you that do DCF's, do you normally do a DCF using FCFE (and discount @ cost of equity) and just focus on the equity? Or, do you do use FCFF (free cash to the whole firm and discount using WACC), back out any debt, to arrive at the value of the equity? I realize that both processes will yield the same value of the equity - but curious if stock investors focus on the whole enterprise or just the equity.

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Degree of Competitive advantage = long term value. If there's another way to think about it that's useful as a forward looking measure.. I haven't found it. Buy with a MOS sell when in full bloom... if it's a compounder the dcf is as strong as the competitive advantages are. The rest is portfolio mgmt and psychology..... knowing is half the battle... psychology is the other half. GI joe was brilliant.

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I found comments by Alice Schroeder to be very insightful on this subject.  She is the one person who has had full access to all of Buffett's files containing years of notes and research.  If I remember correctly, she said she never saw one instance where Buffett actually went through a DCF exercise.  In a speech, she said basically all Buffett looks for is investments where the chance of losing money is near zero.  Then he wants a 15% return on day one. 

 

Here's the speech, which is one of the best, in my view, on how Buffett thinks (start watching at about the 20 min mark):

 

I think others have mentioned it in this thread, but I've heard Buffett explicitly state something to the effect of, "The numbers should jump out at you.  If you have to do anything beyond simple arithmetic to figure it out, walk away."

 

This little gem from Alice about Warren's process helped me enormously years ago.

Keep it simple - precision not necessary. We're dealing with the future for gosh sakes.  Use the back of the envelope and think margin of safety.

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