18. Intrinsic Value – Discounted Cash Flow

[Dave86ch]

Hello investors,

 

I published the latest article on the Value Investing blog.

 

What are we going to learn?

 

- The logic behind the price

- The formula of intrinsic value

- The convergence between value and price

 

https://dscompounding.wordpress.com/2022/04/24/18-intrinsic-value-discounted-cash-flow/

 

I hope it could be useful for novice.

 

Suggestions from seasoned investors are welcome.

[valuehawk91]

Great, will be reading it sometime.

[Bryggen]

On 4/27/2022 at 2:06 PM, Dave86ch said:

Hello investors,

 

I published the latest article on the Value Investing blog.

 

What are we going to learn?

 

- The logic behind the price

- The formula of intrinsic value

- The convergence between value and price

 

https://dscompounding.wordpress.com/2022/04/24/18-intrinsic-value-discounted-cash-flow/

 

I hope it could be useful for novice.

 

Suggestions from seasoned investors are welcome.

Dave86ch, great article,

 

As a newbie, can you explain something in relation to the discount rate, i.e. the use of the risk-free 10 years gov. bond?

Would the discount rate used represent the minimum return the stock would generate should we buy it at its intrinsic value (calculated with this same rate)? 

 

I am just confused. If the risk-free (10 yrs gov. bond) is 4% and I use this rate to calculate the intrinsic value of a stock, then I buy the stock at that specific price, does it means that it will return me a minimum of 4%? I hear people suggesting using a higher rate, say 8%, for better returns. If I use 8% in my calculation, would the intrinsic value obtained mean that if I get the stock at the price, it will return me 8%?

 

I hope I am making sense here. Let me know!

Bry

Edited July 20, 2023 by Bryggen

[Bryggen]

...and my second question is directed at everyone here:

 

Is there any value in using the intrinsic value calculation used by Buffett\Graham in 2023? 

 

Would valuing stock using multiples be easier and sufficiently accurate to make an investment decision?

 

It appears to me that predicting cash flows and determining an accurate or proper discount rate are possible issues in Buffett's valuation method.

 

Thoughts?

 

[longlake95]

It’s more about being right on the cash flow, less so on picking the perfect discount rate. Try using 10%, it’s your opportunity cost %. You have BRK available ( or the S&P 500, you can argue…) to buy which will give you 10% - it’s your hurdle. Whether you use 8.1, 8.9, 10.1, it doesn’t really matter, the value will scream at you. That’s my un-academic view. Others will chime in on risk premium,  WACC, long bond rates….it’s all over kill.

[Gregmal]

Yea I always chuckle at the DCF argument. Know a few fairly well regarded investors. They have to file publicly. One of which was very much a “I require a 12 discount rate” kind of guy. Been negative 3 or the last 5 years and only once beat 12%. Arrogant schmuck….perception meets reality. You require a 12% return, but can’t hit the broad side of the barn at half that…keep at it.

[longlake95]

Agreed, for me a DCF is just one arrow in the quiver. The world is far less linear than a DCF would suggest…lol…

 

I do think it’s a great exercise for newer investors to do, to help wrap their head around absolute value of a business - to disconnect from the typical “ Lowe’s is 15x and the Depot is 20x, so Lowes must be cheap” mentality. 
 

try a DCF on HTL - it doesn’t work…lol…

[Dave86ch]

8 hours ago, longlake95 said:

Agreed, for me a DCF is just one arrow in the quiver. The world is far less linear than a DCF would suggest…lol…

 

I do think it’s a great exercise for newer investors to do, to help wrap their head around absolute value of a business - to disconnect from the typical “ Lowe’s is 15x and the Depot is 20x, so Lowes must be cheap” mentality. 
 

try a DCF on HTL - it doesn’t work…lol…

 

Same thoughts, having a firm grasp on how to perform a discounted cash flow analysis is an excellent exercise, as it helps realize why you're buying a company and define a ballpark price, thereby avoiding getting swept up in hype.

However, as the market becomes increasingly efficient, psychology plays a significant role.

What truly matters is maintaining rationality and grounding your reasoning in reality through a robust mental model of the world.

In my opinion, a solid mental model requires open-mindedness, rationality, and insatiable curiosity.

This not only implies extensive reading, but also active engagement and practice.

Indeed, I began speculating on Bitcoin, and after many years, I feel I'm invested in Bitcoin, even though I can't perform a DCF. This is because I challenged my opinion many times, spent hours reading and coding, until I shaped my mental model into a robust opinion.

This enables me to accept the viewpoints of those who prefer to stay within their comfortable numerical guardrails.

 

 

 

Edited July 21, 2023 by Dave86ch

[Spekulatius]

I use the simple discounted cash flow calculator from Gurufocus:

https://www.gurufocus.com/dcf-calculator?ticker=AAPL
 

 

The value lies mostly to see how changing input parameters like growth rate, length of growth etc impact valuation. You can also calculate backwards to the current valuation (by playing with the input parameters a bit) to determine if a stocks current valuation makes sense to you.

[longlake95]

I used to focus too much on the “numbers”, while they are very important, and the price you pay is VERY important, I learned from WEB & Co, it’s EVEN MORE important to get the business right. That is Waaaay more crucial than your discount rate. 
 

SPEK, yes, looking backwards to see what growth rate is required to justify the current price, might be a better way to look at a DCF If you aren’t susceptible to creeping growth rates. Which I think most market participants waaay over estimate growth over the long pull. 

[ValueArb]

15 hours ago, Gregmal said:

Yea I always chuckle at the DCF argument. Know a few fairly well regarded investors. They have to file publicly. One of which was very much a “I require a 12 discount rate” kind of guy. Been negative 3 or the last 5 years and only once beat 12%. Arrogant schmuck….perception meets reality. You require a 12% return, but can’t hit the broad side of the barn at half that…keep at it.

the funny part is that Buffett and Munger have publicly said he never ever calculates a DCF. One reason is he feels it’s to easy to mislead yourself with one because even small changes to inputs can lead to large changes in estimated value.
 

The essential quote is if value isn’t obvious he just moves in to something else.

[Spekulatius]

1 hour ago, ValueArb said:

the funny part is that Buffett and Munger have publicly said he never ever calculates a DCF. One reason is he feels it’s to easy to mislead yourself with one because even small changes to inputs can lead to large changes in estimated value.
 

The essential quote is if value isn’t obvious he just moves in to something else.

Buffett is a financial math wizard. I think he can do a DCF in his head and that's why I think he doesn't need run a DCF spreadsheet - he has an intuitive understanding how much something is worth that starts with FCF X and growth with Y for Z years. He also uses other frameworks to estimate value.

 

I think running a DCF (or even better a reverse DCF) is a good valuation tool. It's not he end to all but playing with outputs and observing the impact on valuation helps ordinary people like us who can't run these calculations in their head.

Edited July 21, 2023 by Spekulatius

[valueseek]

@Spekulatius Thanks for the gurufocus tool. Nice quick one as a check.

[ValueArb]

3 hours ago, Spekulatius said:

Buffett is a financial math wizard. I think he can do a DCF in his head and that's why I think he doesn't need run a DCF spreadsheet - he has an intuitive understanding how much something is worth that starts with FCF X and growth with Y for Z years. He also uses other frameworks to estimate value.

 

I think running a DCF (or even better a reverse DCF) is a good valuation tool. It's not he end to all but playing with outputs and observing the impact on valuation helps ordinary people like us who can't run these calculations in their head.

He’s definitely a whiz at doing compounding math in his head (munger always carries a table with him). But that’s a small fraction of a the math needed for a DCF which also would involve keeping numerous partial values in your head.

 

But he’s told us exactly. He didn’t say he did it in his head, or didn’t write it out. Charlie said he flat out didn’t do any, and Warren agreed with him.

https://nvariant.substack.com/p/why-warren-buffett-never-calculates

 

I think the reality is he has memorized the relative values of various growth rates and durations, so for example he knows how much more it is worth paying for a 20x growth vs a 12% growth. And I don’t think he even estimates a precise value, from his comments I believe he focuses on relative value. If he finds something that is clearly a better value than most of his portfolio, he buys it.

 

Petrochina is a good example. His quote was essentially it was worth around  $100B and trading for $35B. He didn’t need to know if it was worth $95B or $105B. If it was worth $40B it would require more analysis but it wouldn’t be worth the effort.

 

https://www.eaglepointcap.com/blog/petrochina-case-study-of-a-one-foot-hurdle

 

Again this is typical Buffett who will tell you that estimating value isn’t the hard part, it’s avoiding bias. He refuses to look at stock prices before he’s estimated the value, so he’s not influenced to subconsciously increase his estimates for businesses he loves. DCFs don’t make sense because minor errors in your estimate of future events can radically change the estimated value. 

[Thrifty3000]

Buffett does write out relevant information of interest on the cover and in the margins of annual reports.

 

He doesn’t do formal DCF because he already knows the hurdles he needs to hit, so he just has to predict the odds of hitting a given hurdle.

 

For example, to earn a 15% compound return Buffett knows the value of an asset has to double in 5 years and quadruple in 10 years.

 

Buffett just has to decide whether he can reasonably predict the value in 5 or 10 years and then he pulls the trigger if he can buy the asset for half to a fourth of that future value today.

 

He also has a number of tricks up his sleeve that allow him to juice returns. For example:

 

- he knows a 1% price increase can increase profit by 10% (why he likes sticky products). He pushes companies to raise prices after he buys.

 

- he knows Berkshire gets a much better interest rate than the company could get on its own. Recap that debt, reduce the interest expense, and increase profit margin.

 

He also knows he doesn’t need to hit grand slams every time because the insurance float provides a lot of leverage which helps juice the ROE, even when an investment earns sub-par returns. 

Edited July 22, 2023 by Thrifty3000

[Spekulatius]

I use DCF’s ins a relative sense to put some numbers on qualitative assessment I am doing:

 

1) if I think a business will deliver consistent results with low cyclicality I lower the discount rate a bit

2) If I think a business has a longer runway, or large addressable market I increase the number of years for the growth period.

3) If I think a company growth faster, I adjust the growth rate (that one is pretty obvious).

 

In all cases, I start with a qualitative assessment and do adjustments to the input which puts a value on those qualitative adjustments. While I can in no way assume my adjustments are correct, I think they should be directional correct (or my qualitative adjustment are just plain wrong) and it helps giving me valuation ranges based on quality factors. I use the Gurufocus DCF calculator for this and often does this in a “reverse DCF mode” where I calculate back to the current EV and then determine if the underlying inputs are conservative or seem stretched.

 

 

Edited July 22, 2023 by Spekulatius

[SharperDingaan]

The problem with DCF is that it's used as a substitute for practical experience; those with no idea, relying on a number that the DCF model spat out ... 'cause it must be true! 'cause all the assumptions you made are reasonable! even though you know squat! Sure .... but your boss needs a number, and your job is to sell it .....

 

What will move the dial; is selling goods at a higher price today, selling a higher volume today, and doing it at a lower cost/unit today. Probability of success x magnitude of the change, delivered within 12 months, that Mr Market is willing today to sell at cents in the dollar. Precisely what WEB does.

 

SD

[Gregmal]

56 minutes ago, SharperDingaan said:

The problem with DCF is that it's used as a substitute for practical experience; those with no idea, relying on a number that the DCF model spat out ... 'cause it must be true!

100%. I’ve never really seen a case where a DCF was applied by people who actually understood the businesses. It’s always by some excel warrior trying to find a blanket approach to arrive at a simplified way of valuing something that probably requires a bit of work and/or industry specific experience.

Edited July 22, 2023 by Gregmal

[SharperDingaan]

1 hour ago, Gregmal said:

100%. I’ve never really seen a case where a DCF was applied by people who actually understood the businesses. It’s always by some excel warrior trying to find a blanket approach to arrive at a simplified way of valuing something that probably requires a bit of work and/or industry specific experience.

 

Pray that you never see how soon-to-be CFA's attempt to forecast EV/share from pro-forma financials 

Most with fuzzy accounting knowledge, unable to deal with ambiguity (return on equity calculation methods), and unable to question (terminal value assumptions); yet everybody sure there is only one EV/share! Compounds again when the selections are plugged into portfolio optimises.

 

Makes betting against promoted stock, a lot less risky that it initially appears;

as all those DCF errors, and questionable correlations are additional margin of safety!

 

SD

[Spekulatius]

The worst DCF’s I have ever seen were Excel model for large Capex expenses that were mandatory as a decision tool. There was a very high hurdle rate (I think it was higher than 20%) and those models were massaged until the hurdle rate was exceeded.

 

You also had to exceed it a bit, because of margin of safety. I have never seen a management backed project that failed because it didn’t meet the hurdle rates on paper. In some cases, costs were reduced by omitting equipment or expenses that were prudent to reduce risk, which of course increased the rate of return in that DCF model but increased the execution risk (which didn’t show up on the spreadsheet). So this thing was gamed basically by design.

Edited July 22, 2023 by Spekulatius

[ValueArb]

On 7/22/2023 at 4:13 AM, Thrifty3000 said:

Buffett does write out relevant information of interest on the cover and in the margins of annual reports.

 

He doesn’t do formal DCF because he already knows the hurdles he needs to hit, so he just has to predict the odds of hitting a given hurdle.

 

For example, to earn a 15% compound return Buffett knows the value of an asset has to double in 5 years and quadruple in 10 years.

 

Buffett just has to decide whether he can reasonably predict the value in 5 or 10 years and then he pulls the trigger if he can buy the asset for half to a fourth of that future value today.

 

He also has a number of tricks up his sleeve that allow him to juice returns. For example:

 

- he knows a 1% price increase can increase profit by 10% (why he likes sticky products). He pushes companies to raise prices after he buys.

 

- he knows Berkshire gets a much better interest rate than the company could get on its own. Recap that debt, reduce the interest expense, and increase profit margin.

 

He also knows he doesn’t need to hit grand slams every time because the insurance float provides a lot of leverage which helps juice the ROE, even when an investment earns sub-par returns. 

 

From everything I've read on Buffett this sounds like an excellent assessment on what he does today, with that ginormous portfolio limiting his options in the public stock market but giving him huge leverage in acquisitions and influence over stocks he can invest in.

 

But when he was starting out in 50s and 60s he didn't have any of that, but also still had the entire universe of stocks to pick from. My theory is why he started without doing DCFs is that he was really focused on net-nets, merger arb, and special situations that all resolved within a year or two so discount to exit value was all he needed to estimate his potential return. 

[ValueArb]

On 7/22/2023 at 9:27 AM, SharperDingaan said:

 

Pray that you never see how soon-to-be CFA's attempt to forecast EV/share from pro-forma financials 

Most with fuzzy accounting knowledge, unable to deal with ambiguity (return on equity calculation methods), and unable to question (terminal value assumptions); yet everybody sure there is only one EV/share! Compounds again when the selections are plugged into portfolio optimises.

 

Makes betting against promoted stock, a lot less risky that it initially appears;

as all those DCF errors, and questionable correlations are additional margin of safety!

 

SD

 

Whenever young person asks me if they need to watch Aswath Damodaran videos, my answer say yes if they are planning to get their CFA or work on Wall Street, probably not if they want to become a value investor doing their own analysis and managing their own portfolio.

 

I think the greatest utility and use of DCFs has been in selling stocks to retail clients. It's a wonderful tool for the buy side analyst who has to come up with a compelling valuation for a research report on a company their bank really wants to do business for, as no number your boss gives you is ever unattainable.

[Bryggen]

Amazing guys! Thank you for your input in answering my question. Very knowledgeable people here!

Truly appreciated.

Bry