How often do you use DCF (or something like it)?

[Sweet]

Sure I’ve played around with it but I’ve never bought a single stock based on DCF valuation.

 

Was playing around there with the DCF calculator on Guru focus, it uses an 11% discount rate.  For those that do use DCF what discount rate do you use?

 

Edited October 12, 2023 by Sweet

[ValueArb]

Buffett never uses them so neither do I.

[vinod1]

Reminds me of this joke.

There are these two young fish swimming along, and they happen to meet an older fish swimming the other way, who nods at them and says, “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes, “What the hell is water?”

 

You are using DCF if you are valuing a company with any method other than comparative valuation.

 

What you really mean is that you dont actually lay out the FCF and actually discount it back. You might be using a short cut like 15x Earnings. But underneath that you are making assumptions about required return, expected growth, etc. Only you are doing it implicitly. All valuation ends up being some form of DCF. 

 

Buffett does DCF, he is just able to do the basic math in his head. His short cut method is pretty well covered by his biographer. 

 

For most investors, until they become very good at it and understand the impacts, actually laying out a DCF is an extremely useful way to pick up nuances in valuation that are easy to miss. 

 

As another old dude is fond to say not learning this, "you go through a long life like a one-legged man in an ass-kicking contest. You're giving a huge advantage to everybody else."

 

Vinod 

 

 

[valueseek]

I have used it as a check - more reverse one. To Vinod's point, I remember Buffett pointing several times the value of a security being the discounted cash flows. The minutia of details and assumptions and a standard process are for everyone to get to. With multiples, there is some kind of DCF embedded in anyways. Every situation is different - so there are a variety of industries (eg. banking) and asset situations (real estate), where DCF is not the norm. generally. DCF would just be a tool - imho more in stock analysis is about one's experience, psychological makeup, decision making and pattern recognition. 

[Sweet]

Seems to me that if you have to take out a the DCF calculator it’s probably not worth buying.  I think opportunities should be obvious.  Exception is maybe growth companies, but even then I’ve never used it.

[Luca]

I end up doing relative valuations most often, estimating a conservative growth rate and conservative terminal value with an earnings or FCF multiple. If you purely only discount the cashflows, the assumption is that the business will be sold in the final year. So terminal value becomes the next question, perpetual growth rate formula IMO distorts intrinsic value to much to the upside, punching a 15x-20x multiple on it is fair most often and if you still end up with close to 10% returns with conservative assumptions it looks worth investigating.

 

I remember a friend of mine most often adds a 10-15% margin of safety but you rarely get that nowadays. Already happy enough if the business is high quality and gets you to 10% without tuning the growth rates and exit multiple too much...

Edited October 13, 2023 by Luca

[RedLion]

19 hours ago, vinod1 said:

Reminds me of this joke.

There are these two young fish swimming along, and they happen to meet an older fish swimming the other way, who nods at them and says, “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes, “What the hell is water?”

 

You are using DCF if you are valuing a company with any method other than comparative valuation.

 

What you really mean is that you dont actually lay out the FCF and actually discount it back. You might be using a short cut like 15x Earnings. But underneath that you are making assumptions about required return, expected growth, etc. Only you are doing it implicitly. All valuation ends up being some form of DCF. 

 

Buffett does DCF, he is just able to do the basic math in his head. His short cut method is pretty well covered by his biographer. 

 

For most investors, until they become very good at it and understand the impacts, actually laying out a DCF is an extremely useful way to pick up nuances in valuation that are easy to miss. 

 

As another old dude is fond to say not learning this, "you go through a long life like a one-legged man in an ass-kicking contest. You're giving a huge advantage to everybody else."

 

Vinod 

 

 

Didn’t buffet also do comparative valuation? I remember him talking about workouts buying the best company in an industry at lower valuations and then shorting competitors. But then there was a comment about how just buying the lower priced industry leader at a lower valuation was all it took to be successful with no shorts or workouts needed. 
 

Maybe I’m crazy, I can’t remember for the life of me where or when I read this. Probably 15 years ago when I was doing my Buffett deep dive. Or maybe I’m mistaken and this wasn’t Buffett at all. 

[KCLarkin]

20 hours ago, vinod1 said:

Buffett does DCF, he is just able to do the basic math in his head. His short cut method is pretty well covered by his biographer. 

 

For most investors, until they become very good at it and understand the impacts, actually laying out a DCF is an extremely useful way to pick up nuances in valuation that are easy to miss. 

 

Buffett doesn't really use DCF, at least according to the sources I've seen. He uses something more akin to a hurdle rate. It is easier and more intuitive and I'm frankly baffled that people use DCF*.

 

Company A is worth $100 and is trading at $50, tells me very little.

Company B is expected to return 15% per year, tells me a lot.

 

Example A, I guess, makes sense for cigar butt traders. You need a buy target and a sell target. Or if you are doing a private deal where the price is negotiated.

 

* Building a detailed model and seeing how different assumptions impact valuation is a fun and valuable experience, but I'm doubtful it will improve most peoples returns.

 

---

I'm assuming the biographer you were referring to was Alice. Here is how she describes his process:

 

He looked at them in great detail like a horse handicapper would studying the races and then he said to himself, ―I want a 15% return on $2 million of sales and said, Yes, I can get that.‖ Then he came in as an investor.

OK, what he did was he incorporated his whole earnings model and compounding (discounted cash flow or DCF) into that one sentence. He wanted 15% on $2 million of sales (a doubling from $1 million current sales). Why does he choose 15%? Warren is not greedy, he always wants 15% day one return on investment, and then it compounds from there. That is all he has ever wanted and he is happy with that. ...You are not laughing, what‘s wrong? (Laughs)

It is a very simple thing, nothing fancy about it. And that is another important lesson because he is a very simple guy. He doesn‘t do any DCF models or any thing like that. He has said for decades, ―I want a 15% day one return on my capital and I want it to grow from there-ta da!

[vinod1]

Like I said, he does not need to put FCF for year 1 this much, FCF for year 2 this much and so on to build out a DCF model. But DCF is essentially the only only way to actually calculate IV. The model laid out by Alice is based off DCF with assumptions plugged in. He does not do DCF is something both Alice and Munger mention, but it does not mean what you think it means.

 

If you look at How Inflation Swindles the Equity Investor, he lays out exactly the behavior of how the inputs to DCF behave and how it impacts IV. That is the essence of using DCF. 

 

I know a lot of value investors take pride in saying "I dont do DCF". Once you do understand how earnings, FCF, reinvestment are working, you dont have to actually lay out FCF1, FCF2.... FCF in perpetuity to actually calculate value. Then you take a short cut to DCF valuation, but underlying it is essentially DCF.

 

The mistake I made when starting out and for several years, is look down upon DCF and missed a lot of the insight it provides. I spend several months reading up Damodaran's Investment Valuation and it really opened my eyes. Assuming you are at the same level as Buffett and hence does not need to do some of the things just because he does not do it, is not wise. 

 

Vinod

[Morgan]

@vinod1 Great post Vinod. Totally agree. I don't use DCF now, but I did in my finance classes during undergrad so I learned the nuances of it. Even though I don't use it now, it has some relevance.  

[valueseek]

There's a change in this interview Todd Finkle probably lied about Buffett telling him using DCF to value businesses.

 

 

Anyways, for most businesses, DCF is the way transactions are done in the world. They are done on multiples eventually but it is an output from the DCF. Again, it is not to be said that one uses DCF he/she has forgotten to do much of the other things (diligence, knowing the industry, quality of business, management, etc.). Also, one can get a dcf on anything but one of the key metrics tends to be ROC in an operating business. All such metrics can be easily gotten ahead or from the DCF (for eg. ROC - NOPAT+DnA-maint. capex/Net ppnE, accumutaled dep., non-cash int. bearing liabilities).

 

Buffett is on another planet. he has 70-80+ years of experience. Maybe after the first 1-2 decades, one doesn't need any calc. Also, depends on the inv. understanding and philosophy that keeps on evolving over time for most. Starting with a sub 15PE and some growth, all things equal starts off with a 10%+ return - so there are always different methods for everyone. I think having a consistent process is important at least for me yet turning as much rocks possible. DCF can be used to come at the market expectations of most operating businesses. I am in all probability rambling so will stop.

[Gregmal]

Value investors often cite this. Then they tell you they own gold….

[SharperDingaan]

DCF valuation is an industry practice, and not going away. The investor simply chooses whether to use it ($50 price per report 'X'), do their own quick and dirty DCF valuation, or do a comparatives valuation and re-engineer the DCF valuation backward; pros and cons to each approach. Realising the how/what DCF valuation does matters; the number itself is just a product of the assumptions that went into it.

 

Every company's future looks brilliant 4 years out; but discount it at 25%/yr for the risk involved, and that future dollar is only worth 41 cents (1/(1.25)^4). The DCF value-add is understanding that if that future dollar can be pulled forward by one year it is worth 51 cents (1/(1.25)^3), or the same as a 25% increase in that 4-year dollar (1.25/(1.25)^4). To reliably make that happen most companies would be looking to acquisitions, the resultant growth rate would contribute to higher DCF valuations, and the industry would be publishing reports with ever rising price targets  At times, you might also bet against the implied growth assumption, and benefit from the inevitable 'corrections'.

 

Comparatives assume norms, and don't work well on outliers; the valuation itself is typically just a multiple of forecast one year cash flow, that can be readily dis-aggregated into product volume x price deck (o/g, mining, commodities, etc.). Plug actual prices into the price deck, apply the multiple to find out what the outlier is really worth, and buy/sell accordingly  

 

Then keep in mind that if there is zero future cash flow, the DCF is zero, and the asset is worth zero. After which along comes Bitcoin with zero future cash flow and a current valuation of USD 26,800 .... rubbing industry's face in the fact that DCF as a valuation tool is utter sh1te 

 

SD

 

 

 

  

Edited October 15, 2023 by SharperDingaan

[KCLarkin]

7 hours ago, vinod1 said:

I know a lot of value investors take pride in saying "I dont do DCF". Once you do understand how earnings, FCF, reinvestment are working, you dont have to actually lay out FCF1, FCF2.... FCF in perpetuity to actually calculate value. Then you take a short cut to DCF valuation, but underlying it is essentially DCF.

 

The mistake I made when starting out and for several years, is look down upon DCF and missed a lot of the insight it provides. I spend several months reading up Damodaran's Investment Valuation and it really opened my eyes. Assuming you are at the same level as Buffett and hence does not need to do some of the things just because he does not do it, is not wise. 

 

Vinod

 

This is all true, in a way. But the problem with DCF is that if you actually knew FCF1....FCFN, the proper discount rate is... maybe 5%....the 30yr treasury rate?

 

The whole point of the risk premium is that you don't know FCF1...FCFN. And if you don't know FCF1...FCFN, you can't do DCF. And intrinsic value is only apparent in retrospect. So the U.S. stock market, over the past 100 years was almost always ridiculously undervalued. And one of Buffett's main insights was that, if you were an insurer, if you bought stocks with reasonably predictable coupons ("equity bonds") with your float instead of bonds you would clean up.

 

And so this gets to the main problem with DCF. If you use a "discount rate", you will almost certainly decide that Costco at 40x earnings is "expensive". And VSCO at 5x earnings is "cheap". But this neglects the fact that Costco is closer to a bond with a growing coupon. And VSCO is closer to an out-of-the-money call option. And Costco probably deserves a 6% discount rate. And VSCO probably deserves a 20% discount rate. And which is "cheaper"? Who knows.

---

And so what happens is that price drives sentiment. And the "DCF" shadows price action. And it becomes useless in actually picking investments.

---

In the past year, Meta has traded at $89 and at $330. Intrinsic value has probably not changed a single dollar in that time. What is the IV of Meta? Probably somewhere in the range of $50 to $1000. So obviously, you should buy below $50 and sell above $1000. But what the hell do you do in between?

---

You mentioned Damodaran, who I admire. I looked up a few of his valuations of Meta:

 

2018 - $181 (stock at $155)

2022 - $346 (stock at $220)

2022 - ~$100 in a "doomsday scenario" (stock at ~110)

 

And to be fair, he was correct that Meta was undervalued all three times. So I guess DCF does work... if you are as skilled as, perhaps, the most famous "valuation" expert. But it is devilishly imprecise and definitely an art form. Doesn't mean you can't admire and learn from the fundamental truth of Intrinsic Value.

[competitive-advantage]

I did use it on Apple when I invested back in the beginning of January. I just used the standard values and then waited for a little more than 20% margin of safety because there were some bad regulatory news that I needed extra margin for back then. At the moment it's the best valuation technique I got, but I'm studying Business Administration and reading a lot etc. on the side, so I will get more skills and knowledge to use in the future.

Edited October 15, 2023 by competitive-advantage

[sholland]

As mentioned above, P/E multiples are a shortcut for DCF.

If you have a steady business (no growth, but no decline) it should be worth roughly 10x owner earnings.

Throw in some growth and you might justify a P/E multiple of 15. 

Some extreme high growth companies like Google & Facebook in their heyday justified very high P/E multiples. 

I believe that every beginner should verify what I said above with DCF models and get a feel for the process. Once you get a feel then you will not need DCF. 

[vinod1]

18 hours ago, KCLarkin said:

 

This is all true, in a way. But the problem with DCF is that if you actually knew FCF1....FCFN, the proper discount rate is... maybe 5%....the 30yr treasury rate?

 

The whole point of the risk premium is that you don't know FCF1...FCFN. And if you don't know FCF1...FCFN, you can't do DCF. And intrinsic value is only apparent in retrospect. So the U.S. stock market, over the past 100 years was almost always ridiculously undervalued. And one of Buffett's main insights was that, if you were an insurer, if you bought stocks with reasonably predictable coupons ("equity bonds") with your float instead of bonds you would clean up.

 

And so this gets to the main problem with DCF. If you use a "discount rate", you will almost certainly decide that Costco at 40x earnings is "expensive". And VSCO at 5x earnings is "cheap". But this neglects the fact that Costco is closer to a bond with a growing coupon. And VSCO is closer to an out-of-the-money call option. And Costco probably deserves a 6% discount rate. And VSCO probably deserves a 20% discount rate. And which is "cheaper"? Who knows.

---

And so what happens is that price drives sentiment. And the "DCF" shadows price action. And it becomes useless in actually picking investments.

---

In the past year, Meta has traded at $89 and at $330. Intrinsic value has probably not changed a single dollar in that time. What is the IV of Meta? Probably somewhere in the range of $50 to $1000. So obviously, you should buy below $50 and sell above $1000. But what the hell do you do in between?

---

You mentioned Damodaran, who I admire. I looked up a few of his valuations of Meta:

 

2018 - $181 (stock at $155)

2022 - $346 (stock at $220)

2022 - ~$100 in a "doomsday scenario" (stock at ~110)

 

And to be fair, he was correct that Meta was undervalued all three times. So I guess DCF does work... if you are as skilled as, perhaps, the most famous "valuation" expert. But it is devilishly imprecise and definitely an art form. Doesn't mean you can't admire and learn from the fundamental truth of Intrinsic Value.

 

There seems to be 3 main points of contention 

1. One cannot know FCF that are going to be generated in future

2. One does not know what discount rate to use

3. If you use a conservative FCF and discount rate, you find many stocks expensive

 

Points 1 & 2

1 & 2 are closely related and general argument by some is that they are too uncertain. As one person put it, discount rate is like using the Hubble telescope, a small change and you are in a different galaxy. All true. But every single valuation method other than relative valuation suffers from the same thing. All the shortcut valuation methods you use have the same problem.  Let us take the example of using 10x earnings for valuation. Here you are making assumptions about FCF and discount rate (a) all of earnings are FCF (b) a discount rate of 10% and since no reinvestment, you are assuming 0% growth. This is DCF model in disguise, but here you have implicitly assumed things which you are deathly afraid of explicitly putting into the model. 

 

When I use to play basketball with my daughter when she was 5 or 6 years old, she used to close her eyes whenever is ball looked like hitting her. To her it seemed just the fact of closing her eyes, seemed to sweep away the risk of the ball hitting her.

 

Saying, you are not using DCF is the same exact thing. You are sweeping away the assumptions.

 

Future is uncertain. Cash flows are uncertain. World is unpredictable. DCF valuation reflects that uncertainty. Embrace it. 

 

Point 3

It is like saying, I dont want to risk any money in stock market but want 15% returns. There is no point in valuing something conservatively and saying it looks expensive. Value what you think cash flows are going to be. Project it out several years. It is not DCF that is stopping you from buying. 50x earnings does not make something expensive. It looks expensive. You already know that so I would not belabor that point. 

 

To you point about Damodaran, DCF calculation is not really the tough part. He is a good teacher. The mechanics are very simple. The tough part is understanding the business enough to know as he puts it "the story" or as Buffett says the moat and how sustainable that is.

 

Vinod

[vinod1]

5 minutes ago, sholland said:

As mentioned above, P/E multiples are a shortcut for DCF.

If you have a steady business (no growth, but no decline) it should be worth roughly 10x owner earnings.

Throw in some growth and you might justify a P/E multiple of 15. 

Some extreme high growth companies like Google & Facebook in their heyday justified very high P/E multiples. 

I believe that every beginner should verify what I said above with DCF models and get a feel for the process. Once you get a feel then you will not need DCF. 

 

You say it so much better that I do!

[vinod1]

 

10 Myths about the DCF Model

https://pages.stern.nyu.edu/~adamodar/pdfiles/country/DCFmythsTemasek.pdf

[Luca]

30 minutes ago, sholland said:

As mentioned above, P/E multiples are a shortcut for DCF.

If you have a steady business (no growth, but no decline) it should be worth roughly 10x owner earnings.

Throw in some growth and you might justify a P/E multiple of 15. 

Some extreme high growth companies like Google & Facebook in their heyday justified very high P/E multiples. 

I believe that every beginner should verify what I said above with DCF models and get a feel for the process. Once you get a feel then you will not need DCF. 

Are you sure about 10x earnings for GDP/Inflation growth as a general rule? It depends on interest rates, maybe 10x is fine at 5%+ rates but at 2% rates, a high quality company that is in a saturated market, has a strong moat and pays 80% of cashflows via dividend shouldnt trade at 10x. If you take 10x as your exit multiple you wont find anything that looks good because quality still trades at 20x+ because it almost pays as much as bonds right now and can continue grow those 5% earnings but bonds can not. 

 

Id say that moaty high quality businesses with little growth left but that will grow sales with inflation and keeps margin stable should still trade a bit less than risk free rate.

[sholland]

1 hour ago, Luca said:

Are you sure about 10x earnings for GDP/Inflation growth as a general rule? It depends on interest rates, maybe 10x is fine at 5%+ rates but at 2% rates, a high quality company that is in a saturated market, has a strong moat and pays 80% of cashflows via dividend shouldnt trade at 10x. If you take 10x as your exit multiple you wont find anything that looks good because quality still trades at 20x+ because it almost pays as much as bonds right now and can continue grow those 5% earnings but bonds can not. 

 

Id say that moaty high quality businesses with little growth left but that will grow sales with inflation and keeps margin stable should still trade a bit less than risk free rate.

“The value of a business is the present value of all the future cash flows expected to occur over the lifetime of a business which is discounted at an appropriate discount rate.” - Warren Buffett

 

Whether the business has a moat or not does not enter into the DCF calculation.  The rules of thumb I presented are just my 1st level approximations. You are correct to think in 2nd and 3rd levels about the value of a business.

Edited October 15, 2023 by sholland
Clarification: obviously the presence of a moat increases the confidence level of the predicted future earning streams

[ValueArb]

23 hours ago, vinod1 said:

 

There seems to be 3 main points of contention 

1. One cannot know FCF that are going to be generated in future

2. One does not know what discount rate to use

3. If you use a conservative FCF and discount rate, you find many stocks expensive

 

Points 1 & 2

1 & 2 are closely related and general argument by some is that they are too uncertain. As one person put it, discount rate is like using the Hubble telescope, a small change and you are in a different galaxy. All true. But every single valuation method other than relative valuation suffers from the same thing. All the shortcut valuation methods you use have the same problem.  Let us take the example of using 10x earnings for valuation. Here you are making assumptions about FCF and discount rate (a) all of earnings are FCF (b) a discount rate of 10% and since no reinvestment, you are assuming 0% growth. This is DCF model in disguise, but here you have implicitly assumed things which you are deathly afraid of explicitly putting into the model. 

 

When I use to play basketball with my daughter when she was 5 or 6 years old, she used to close her eyes whenever is ball looked like hitting her. To her it seemed just the fact of closing her eyes, seemed to sweep away the risk of the ball hitting her.

 

Saying, you are not using DCF is the same exact thing. You are sweeping away the assumptions.

 

Future is uncertain. Cash flows are uncertain. World is unpredictable. DCF valuation reflects that uncertainty. Embrace it. 

 

Point 3

It is like saying, I dont want to risk any money in stock market but want 15% returns. There is no point in valuing something conservatively and saying it looks expensive. Value what you think cash flows are going to be. Project it out several years. It is not DCF that is stopping you from buying. 50x earnings does not make something expensive. It looks expensive. You already know that so I would not belabor that point. 

 

To you point about Damodaran, DCF calculation is not really the tough part. He is a good teacher. The mechanics are very simple. The tough part is understanding the business enough to know as he puts it "the story" or as Buffett says the moat and how sustainable that is.

 

Vinod

the reason Buffett has given for why he doesn’t calculate DCFs is that they make it too easy to fool yourself. If you love the business but the DCF valuation isn’t high enough it’s easy to tweak a couple inputs just a small amount and voila! It’s now a bargain.

 

you are correct that using a PE or PEG ratio is just establishing of thumb based on a theoretical DCF. If you use them you should run DCFs at various growth rates , durations and with different risk free rates to get a feel for how these factors change relative value as they change. But then you no longer have any need to calculate DCFs for any investments, you know if growth rate is roughly X% for Y years what a good valuation should be, and if growth period increases how much value will increase.

 

Getting back to Buffett’s objections, all valuations are estimates and should be ranges. The hyper precision of an individual DCF is misleading, and a waste of time. You simply can never know the true growth rate and period with any accuracy.

[Spekulatius]

21 hours ago, sholland said:

Whether the business has a moat or not does not enter into the DCF calculation.  The rules of thumb I presented are just my 1st level approximations. You are correct to think in 2nd and 3rd levels about the value of a business.

The moat is not a direct input in a DCF model but an indirect one via the length of growth or perhaps in the margins (if you model goes into this detail) or perhaps the discount rate.  If for example you subjectively assume that the probability that the moat is going to be narrower/less deep in the future, you can handicap this with a higher discount rate.

 

Anyways, the value of a DCF (or reverse DCF) is not the number that you are getting, but the range of outcomes you can obtain based on the variance of your input parameters (like rate of growth, duration of growth).

[Gregmal]

Put differently, I’ve never found a single investor who has successfully and consistently been able to make investments with ANY sort of accuracy, using DCF. I can point to a few who’ve gotten themselves into a bunch of trouble using it. 

[coc]

I don't think what Buffett does is any more complicated than looking at the market itself, cash, and long term bonds as alternatives and then assuming he can do better, so what is the most attractive thing he can find better than 16x P/E for a 6.5% grower with a 12%-15% ROE (the market)?

 

Apple when he bought it was <10 P/E growing around the same 6-7% rate with an infinite ROE and he deemed the moat to be solid (and was correct). It didn't take a DCF to see it was mispriced on a relative basis if his qualitative judgment was right. Obviously relative to a 3% long bond (then) or 5-6% long bond (now) it was still a much better investment. Obviously relative to cash earning zero (then) and earning 5.5% (now) it was a much better deal. And he must not have had any superior stock ideas, or he wouldn't have bought so heavily.

 

So relative to all alternatives he understood equally well, it was a bargain and he bought it. Obviously all of the assumptions above only make sense if you're thinking in a DCF-adjacent way, but you wouldn't need a model.

 

Valuation becomes more relevant when you have to sell and we all do that poorly including Buffett himself arguably. 

Edited October 16, 2023 by coc