There’s no such thing as certain future real cash flows outside of a textbook in any form of reality.
Not to mention that in arriving at “certain CF”, most practitioners will use some sort of probability methodology which ends up embedding the risk component of the discount rate. Also, a discount rate WAS used as you have to adjust for inflation to arrive at real cf, which is in and of itself a discounted rate / factor depending on how you choose to look at it. Additionally future inflation is not a static or known factor (as assumed in your statement) and again carries information. Yellen will back me up on this.
Virtually all core economic theory will tell you there is a time value, in that a dollar today is worth more than a real dollar tomorrow (and I’m aware you studied econ, and that surely some archaic peice of literature argues otherwise)
Which brings me back around to #1, no cash flow is certain. If I were to get hit by a bus tomorrow, I’d have preferred that CF today.
I mean, in simple terms, why do investments generally create returns creater than the rate of inflation? Compensation for risk (ie lack of certainty). How do most valuation professionals in the field do this? Discount rates (or multiples used as a proxy).
Well, if there is a risk free asset (typically something like a US Treasury security) that is an alternative to an investment with any kind of risk in its future cash flows, and if that risk-free asset has a positive interest rate, then every other asset that has future cash flows - certain or not - has to have those cash flows discounted by at least the same rate as the risk-free asset, else there is an arbitrage opportunity.
I suppose the arguments above say that if the money supply is being manipulated by the government, then the real purchasing power of risk-free assets is no longer certain. Or perhaps they are arguing that since the risk-free asset is basically yielding 0% interest in some cases, then the value of an asset is equal to all future cash flows, undiscounted.
Even if there is 0 time value for money, it still seems that there should be a discount for risk. One reason why I generally prefer $50 to a 50-50 chance of of $0 or $100 is because the utility of $50 (U($50)) is greater than the average of the utilities of $0 and $100 ( = p($0)*U($0) + p($100)*U($100) ) for anyone that is risk averse, and the proper risk premium to apply is at least whatever is required to make those two utilities equal.
Given that utilities are effectively unobservable in any verifiable way, the usual way to get at the risk premium is to look at historical averages or implied figures and assume that they describe revealed preferences or revealed utiities.
However, there is an interesting dynamic if we assume that wealth is becoming more and more concentrated. Generally, wealthier people have lower risk aversion than non-wealthy, because risking your lunch money and ability to pay rent is more damaging to utility when lost than merely risking electronic credits in a bank account. So, as wealth becomes more concentrated, it would suggest that risk premiums are likely to decline, particularly if the wealthy are most interested in competing with each other for wealth and the chance being left without the means of daily survival is almost nill. Other things equal, that would suggest that risk premiums drop, which would tend to increase valuation ratios, so the high valuation ratios may be in part an artifact of wealth concentration and the fact that those who are able to have substantial market assets are not really afraid to suffer drawdowns the way ordinary people are.
I’m on mobile so I’ll have to get back to you later.
When I say real cash flow, I do not mean real prices. I mean expected cash flows not adjusted for future inflation. And only the component that is closest to certainity as you can practically achieve. If that sounds bizzare, then all valuations are bizzare, because expected cash flows AND discount rates are no less hypothetical. Not that I refuse the notion that valuations are a big steaming pile of gunk when you look close enough. But then again, what is?
Perhaps Mr. Smart is saying that a conservative valuation is one that ignores the value of all risky cash flows and adds up the undiscounted (other than expected inflation; EDIT: I misread, I guess that inflation is not important) of “certain” cash flows.
I don’t see how this can work unless you define “certain” in a way like “Higher than X probabilty” where X is something like 95% or 99% and you ignore everything else. If you do that, then you effectively do get a version that is like normal discounted cash flows (discounted for risk), except that instead of taking a 25% discount for risk, you are just ignoring 25% of projected cash flows because you consider them too risky that you assume you won’t get them.
I don’t know how you avoid the time value issue, except that perhaps the method is conservative enough that it effectively incorporates a time value too. Or to say that current RFRs are so low that you can assume a dollar tomorrow is worth a dollar today.
I can see that this might be an approach used in parts of the world where the economy is extremely unstable or prone to inflation or government defaults. Mathematically, it would still boil down to discounted cash flows, just arrived at by other means.
So you’re saying investors ignore the impacts of inflation and time when they value assets? How about when I value a thirty year treasury bond? I know the expected nominal cash flows, how do I get back to my current valuation or how do I decide what the real cash flows are and what do you call that rate?
Can you actually produce a peer reviewed paper that nullifies the time value impact on money and says one certain dollar today is worth one certain real dollar in ten years?
What is your source for any of this? And again, you’ve completely ignored the fact that in an equity valuation there is no certainty, only estimates arrived at through probability. What is the “certain” cash flow on a non-dividend stock?
There is no such thing as a conservative valulation either.
Summing up the risk free cash flows from an asset is not conservative, but an alternative method to arriving at fair value. Incorporating conservativness, or otherwise, in your valuation beats the point in the first place.
It’s not an exact science for how risk free cash flows can be derived (let’s say, equity cash flows in this case). It is quite simillar to expected cash flows that you use in a normal DCF, since the cash flows we commonly see are those most likely to materialise in the absence of systematic risk. Risk free cash flows in this case, would adjust for systematic risk as well, but since this is not quantifiable as an adjustment to idiosyncratic cash flows, a more simpler and equally correct method would be to project ‘certain’ cash flows that is unaffected by any type of risk to a very high degree (any type of risk here would exclude force majure, naturally). You also need to take into account that inflation is automatically priced in normal CF projections, in the form of higher prices coming from forces outside of real supply and demand. The adjustement for inflation here would offset the need to discount at the risk free rate for the time value of money, since inflation is no longer an opportunity cost, and real risk free rates are zero in the abscence of risk, by definition.
It’s simple maths. The certain cash flows of both models would have the bulk of ‘promised’ (for DMs) or 'safe" (for FCFM’s) cash flows in the earlier stages, then disipitating with time, maybe exponentially, depending on the financial and economic structure for the future. This is a lot easier said than done, and both should provide different cash flows for the same period, but simillar aggregate of cash flows if the assumptions are exact. An expected cash flow in a DCF uses weighted-average cash flow for the period, giving you a risk neutral cash flow, for example 80% the company would give $110, and 20% = $60 gives me a risk netural cash flow of $100. While the risk free component would be the certain component of cash flow that he can count on from the firm as an extremely risk averse investor, and this is where it gets tricky. As an investor, this would be subjective, but so would normal expected cash flows as well. You would simply 1) count the cash flows that you feel are fairly certain in the face of systematic adversity, while taking into account the high weight of adversity, given your risk aversion, in the case of adjusting your prior idiosyncratic cash flow, or 2) generate a certain cash flow from scratch using other means, like taking the cash flows in the event of the least tolerable downside scenario for the economy, industry, and company taken into consideration for it’s magnitude. Using the example from above, if only these two scenarios were possible, then a risk averse investor might assume an expected cash flow of $60 for the period (adjusted for dollar inflation if nessecary, or discounted at the risk free/inflation rate), or given a 95% weight to the ‘bad scenario’, roughly 83%*$60 + 17%*$95 = $68. But this assumes that systematic risk is taken care of soley in the form of shifting the probabilty distributions to take market-wide risk into account
That cash flow would decrease by a normal rate of inflation with time (given the fundamentals of the macro and micro economy do not change), or simply discount the $60 by let’s say 4% to get a fair value of $1500.
If the normal DCF were to be used, we assumed an inflation rate of 4%, and an undiversifiable risk of 8%, giving you (100*1.04)/.04 ~ $1500
No reason why this would be different than any other method. It’s simply easier to project expected cash flow, than safe cash flow, and use bloomberg betas and government securities to take care of any other undiscounted risk.
Valuations are risk neutral. At least the widely used valuations which ascribe investor risk neutrality. No adjustments for individual risk aversion are made in this case.
I’m saying investors should ignore both when using the risk free cash flow approach. Using that approach, and assuming that the US treasury is absolutely risk free (it is not). Then you would add up all the future cash flows adjusted for inflation. In the absence of inflation, then the value of a 30-year T-bond would simply become the sum of all future cash flows. In this case, a bond with a face value of $1000 issued at par would have a price of $1000 at any point in time during the 30-year tenor. But this is an oversimplification, in reality, it would be issued at a slight negative interest rate (premium with bullet maturity, or an interim cash payment at par) to account for the cost of storing money.
It’s much more simple than that. Consider this, in a deflationary enviroment, the value of one dollar today is worth less than a dollar ten years from now.
The time value of money is a modern construct built around the devaluation of currency, NOT money.
Money, by definition, has a constant time-value. Currency, however, exceptional cases aside, does not.
^the risk free rate is higher than the rate of inflation. You still haven’t cited any sources saying the time value of money isn’t a thing. The vibe I’m getting from the pages worth of rambling bs reflecting citing your own opinions is that this is primarily just the made up diatribe of a fresh college grad. I especially liked the part about ignoring force majeur. You know, because markets love just ignoring risk and all. But even that wasn’t as good as “I’m not saying investors value assets this way but they should.” Which is even more laughable. This from the guy who joined this thread saying every post was just bull chit.
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there is literally no peer reviewed research saying a real dollar in 100 years is equal to a real dollar now and no way for this system which essentially ignores credit risk to work on a non dividend paying stock. You also keep sidestepping the fact that the theory you’re referring to builds in the discount rate in how “theoretical certain” cash flows are arrived at through probability weights. I’ve got a quant MS in Finance that was focused on valuation theory, I know exactly what you’re referring to but it was an abstract theory that your misunderstanding (it embeds the time value and risk in via stochastic probabilities) and is generally not considered applicable to real world valuations owing to its lack of robustness. You’re trying to dig yourself out by saying otherwise, particularly given the point you’re trying to make.
I mean, how can you write this, and even acknowledge that your idea doesn’t reflect reality, particularly given that the RF rate is generally greater than inflation expectations which reflect shifts in money supply and not realize how ridiculous it is. Your points about tvm basically saying that all other Econ is wrong are even more silly. Your point is falling apart.
Let’s take the arch coal '21s. Coupon about 5%, recovery value somewhere between 0 and 10% depending on market conditions with time frame and legal costs invilved, will likely default sometime within the next 1-4 years, but could survive or see a major swing in recovery value by 3-7x IF met coal prices which are volatile, recover from their nearly all time lows. Where are the certain real cash flows again?
Never said that. But I did make the point that I have enough background to understand what you were trying to say. You have a PhD in Econ and a MS in Finance (me) both telling you that your point does not hold any water. By your own admission it doesn’t reflect market reality or practice and you can’t provide a single source for your erroneous claims nullifying time value of money (based on misunderstanding of a concept meant to demonstrate the parity of stochastic modeling used to account for risk and discount rates) or a method for demonstrating what a “certain real CF” actually is or how it’s arrived at.
Your “analysis” basically centers on denying the concepts of time value of money and discount rates (Damodoran would be amused) while referring to the “notion that valuations are a big steaming pile of gunk” which only further highlights that you’re out of your league.
That’s funny because what I’m trying to say neither requires sources, nor is meant for practical purposes. It is a much more simple thought. I never tried to turn it into a science, not becuse it was implausiable, but impractical.
Does that make it wrong? No. Can I still build a risk-free cash flow model? Yes.
But if you were a MS in Finance, you would have understood what I was really trying to say. And judging by this post, and the ones on this page above, you missed the point completely, and the counter-arguments used to support the off topic point were just as fallible.
and discount rates (Damodoran would be amused) while referring to the “notion that valuations are a big steaming pile of gunk” which only further highlights that you’re out of your league.