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Is DCF useless?

I had a discussion with a guy that claimed he had 5+ years of professional experience in trading, equity research, portfolio construction, and he insisted that DCF valuation of companies is useless. He said that DCF is only good for things like bonds with very stable and predictable cash flow, while DCF for a company requires too much “guessing”. Instead, he uses his own approach with 5 types of analysis (although he admitted that he uses target prices provided by research firms, so basically he still indirectly uses DCF to some extent) and his returns at least two times better than S&P 500 (but he refused to tell any risk-adjusted measure of performance).

I know that DCF is part of CFA level 2 curriculum and I skimmed some textbooks on valuation and I know that there are 3 approaches to valuation (dcf,relative valuation, contingent claim valuation) and each one of these approaches has its constraints and cannot be used in some cases, but I had an impression that DCF is nevertheless a go-to approach to valuation. However, I am outsider to the investment industry so I am still wondering whether DCF is really becoming obsolete and it’s one of those things you learn in college but (almost) never use in real life.
 
So my question to those of you who is professionally involved in companies’ valuation: Is this guy right? Is DCF useless?

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dcf is not useless. in fact it is the cornerstone of all investing.

when you buy an investment wheter a bond or stock, you are essentially hoping that the cash flow you receive at different points in the future will be greater than what you paid today plus interest (discounting factor).

he is right that is is more accurate for bonds as the cash flow is more predictable, but you are still gambling on rate of inflation/interest, the quality of the bond issuer, the attractiveness of other investments (for example if stocks have a dividend yield of 10% vs bond rates at 2%). but the idea that it is not useful for stocks just because of hte difficulty of predicting cash flow is stupid. a good investor is suppose to price that predictability.

one could say that inputting 1 scenario and calling it a day is dumb. you should be able to put multiple assumptions and create a range. for example you cant assume a growth company will grow 20% to perpetuity, like all companies they slow, but when do they slow. at what number do they start becoming stable. and then after that you have to predict its slow to sharp decline. because given its growth rate in terms of income, you’ll get a certain multiple. etc etc.

lastly play with inputs enough and you’ll start to get a rough idea on what anything is worth without doing a dcf.

I love my cheese. I got to have my cheddar.

DCF is not very popular especially for mature companies because of lot of subjectivity involved in deciding inputs. For such companies trading multiples are more preferred. However for early stage, high growth companies DCF is used which takes multiple growth periods into consideration. Nevertheless investment banks use both multiples and DCF based approaches to value stocks and then take either simple average or weighted average of prices (by assigning weights to each method).

Thank you for your answer!

“in fact it is the cornerstone of all investing. “

That’s what I thought, so I was very surprised by his opinion on DCF for stocks.

Thank you, mskhan91!

Dcf and multiples are  no different. The multiple just abstracts away all the assumptions so it makes people feel better 

Yeah, DCF and multiples are somewhat interchangeable, the multiple itself is analogous to the effect of the discount rate.  That said, there are a lot of shops that aren’t big on DCF’s and their applicability can vary between firms given their scenarios.  He’s not “wrong” and I don’t think you’re “wrong” either.

#FreeCVM #FreeTurd #2007-2017

Thank you, rawraw !

Thank you, Black Swan!

Black Swan wrote:

there are a lot of shops that aren’t big on DCF’s and their applicability can vary between firms given their scenarios.

Do they use only multiples? what if multiples are inapplicable for some reason? Or do they have their own proprietary approach that is not based on discounting?

Some do.  I can’t think of a situation where multiples wouldn’t work, particularly if DCF works.  For high growth tech companies sometimes they fall back on sales multiples, a lot of places will back out from an EBITDA multiple.

#FreeCVM #FreeTurd #2007-2017

That’s interesting, i have to read up on multiples and interchangeability of dcf and multiples.

Thank you.

If you are a DCF guy and want to talk to a multiple guy and not feel silly, just calculate justified multiplies that contain the assumptions that matter the most 

Basically you have to realize that in formulating a multiple, you are selecting between EBITDA, Earnings or some other base that carries certain assumptions and the target multiple incorporates aspects like risk and growth.  In this way, the target model is obviously subjective, but what many new analysts don’t initially grasp are that the risk premiums, betas and long term growth rates embedded in DCF models are largely subjective and in many senses the process of selecting those metrics is very similar to the “art” of selecting a multiple.  Both  DCF and model valuation are ultimately going to reflect analyst assumptions.

#FreeCVM #FreeTurd #2007-2017

rawraw wrote:

If you are a DCF guy and want to talk to a multiple guy and not feel silly, just calculate justified multiplies that contain the assumptions that matter the most 

I wouldn’t describe myself as DCF guy and my opponent as multiple guy. For the purpose of above-mentioned discussion I am sort of “why-is-he-so-extremely-negative-about-dcf-that-seems-unprofessional” kind of guy and my opponent is
“dcf-is-rubbish-for-fools-i-invented-a-method-with-5-types-of-analysis” guy.

Good advice for the future though, thanks.

Black Swan wrote:

Basically you have to realize that in formulating a multiple, you are selecting between EBITDA, Earnings or some other base that carries certain assumptions and the target multiple incorporates aspects like risk and growth.  In this way, the target model is obviously subjective, but what many new analysts don’t initially grasp are that the risk premiums, betas and long term growth rates embedded in DCF models are largely subjective and in many senses the process of selecting those metrics is very similar to the “art” of selecting a multiple.  Both  DCF and model valuation are ultimately going to reflect analyst assumptions.

I understand that rates, etc are subjective, at least I think I understand :)
I’m not against multiples per se, just don’t feel that that dcf deserved such negative attitude because of subjectivity and imprecision, as if the alternative is 100% accurate. Besides, it wasn’t dcf vs multiples argument. That guy invented his own method with 5 types of analysis, and multiples approach is only one of the 5, another 4 remain unknown and only god knows how subjective and precise the remaining 4 are.

I swear, I think nearly every stock I’ve bought using a DCF model (not that many) I’ve built has tanked. The ones that I go off Warren B’s questions (do i understand the business, does it have a durable competitive advantage, does it have a good management team, and is it priced right) do well. For that last question, I look at how the company has done over the last 10 years or so, since the recession, and use a few basic multiples. 

FWIW, that’s how I invest my hard earned personal money and family money. Right or wrong, that’s my skin in the game. On the job, I model pretty extensively and honestly, I don’t see the value add. I used to be a big believer too, took courses and all. Maybe I’m a bad modeler, I dunno. Some people will say you can use it to sensitize but you can do that with multiples and the story in your head, at least that’s what i do.

We’re gonna win so much, you may even get tired of winning. And you’ll say, 'Please, please. It’s too much winning. We can’t take it anymore. Mr. President, it’s too much.' And I’ll say, 'No, it isn’t!' We have to keep winning!

Thank you for sharing your experience!

If I understand correctly, on the job you use dcf. Do those stocks also tank?

Ironically enough, the guy I’m talking about also thinks that Buffet’s value investing approach doesn’t work any more. Actually, it was the discussion of Buffet that led to dcf.

Yes they have LOL Never get high on your own supply.

We’re gonna win so much, you may even get tired of winning. And you’ll say, 'Please, please. It’s too much winning. We can’t take it anymore. Mr. President, it’s too much.' And I’ll say, 'No, it isn’t!' We have to keep winning!

Modeling is useful but more in testing market assumptions.  Like you build a model and true it up to consensus forecasts so that it’s generally equivalent.  Then you start testing those assumptions for sensitivity, robustness, reasonability, etc.

#FreeCVM #FreeTurd #2007-2017

also on the dcf note. many people actually incorporate a multiple at the very end. for a growth company for instance, some want to sell b4 the growth slows down so people just end it  in like 3-5 years for example and apply a high multiple on the last year’s cash flow.

for a typical value company that buffett wants to invests in, he usually wants a company with predictable cash flows in the long run that will stand the test of time. so he usually doesnt incorporate an end multiple. The idea is that he wants to own it forever because he likes the business. that the co has an edge. and that no innovation will erode that edge.

I love my cheese. I got to have my cheddar.

DCF is not useless its the people who are using it

"You want a quote? Haven’t I written enough already???"

RIP

Thank you all for sharing your thoughts. That was helpful.

In general, DCF’s tend to have an overblown reputation among academics (because it fits in well with theory) and people who have never been paid to professional value anything (because it sounds precise).  Not personally directed just an observation based on what I see from students etc.  I mean its definitely a necessary skill to have if you’re applying for jobs, but needs to be kept in perspective.

#FreeCVM #FreeTurd #2007-2017

Black Swan wrote:
(because it fits in well with theory) and people who have never been paid to professional value anything (because it sounds precise).

There’s definitely something to it :) I guess it’s also some psychological need in predictability, stability, whatever.

an interesting buffett answer on how to determine intrinsic value: tldr, its dcf

https://youtu.be/TmWW7tsCuGQ?t=119

people in our industry are more obssesed about relative multiples though because its about the current environment, but honestly thats just comparing the current price of  an eps. has nothing to do with intrinsic value. an example if a was acquired at this multiple then mine should trade at that multiple as well. 

I love my cheese. I got to have my cheddar.

Nerdyblop wrote:

an interesting buffett answer on how to determine intrinsic value: tldr, its dcf

https://youtu.be/TmWW7tsCuGQ?t=119

people in our industry are more obssesed about relative multiples though because its about the current environment, but honestly thats just comparing the current price of  an eps. has nothing to do with intrinsic value. an example if a was acquired at this multiple then mine should trade at that multiple as well. 

False man, for a Buffett acolyte you should know better:

1996 Berkshire Hathaway Annual Meeting:

Buffett: “We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind. We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher?”

Munger: “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”

Buffett: “It’s true. If [the value of a company] doesn’t just scream out at you, it’s too close.”

—————-

Buffett: “That’s what we do. If you need to use a computer or calculator to figure it out, you shouldn’t [buy the investment]. Those types of [situations] fall into the “too-hard” bucket. It should be obvious. It should shout at you, without all the spreadsheets. We see something better.

—————-

Munger: Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something.

#FreeCVM #FreeTurd #2007-2017

lol, yea but you do undestand that just because he didnt do a speadsheet doesnt mean its not dcf.

he did dcf, he just did it mentally. 

I love my cheese. I got to have my cheddar.

I hear you, I do understand the general point that yes, he looks at cash flows and considers his rate of return in a back of envelop that’s 15% a year sort of way.  I think that’s about as far as he goes on that having read through a lot of the material out there from him and Munger.  But to my point, there’s literally no difference between doing that sort of back of the envelope “DCF” analysis and a multiple valuation.  If you’re doing a simple I’m looking for 15% FCF to EV type analysis there is no mathematical difference to saying you want to pay 6.7x FCF or whatever.  You just invented a back of the envelope DCF in your head WB style.  You take it a step further and just proxy FCF with EBITDA and you just reinvented multiple valuation.

Which is sort of my point, it’s just two ways of arriving at the same conclusion.  The only scenarios where they begin to differ are when you start wading into finer point computational complexities or nuance that a multiple may not be able to cover, but in those cases, I’d redirect you to the WB quote above.

#FreeCVM #FreeTurd #2007-2017

To clarify, I’m not saying a great analyst can’t rely exclusively on DCF if that’s what they like, I’m just saying an equally great analyst can reach the same conclusions using multiples.

#FreeCVM #FreeTurd #2007-2017

its a bit different imo. multiples look at 1 year earnings. granted they may apply a cheap/expensive multiple depending on the outlook of the business. like they do to energy cos during peak earnings when oil prices are high.

personally when i look at an earnings multiple, i look at it as how many years it will take to earn what i paid. which is stupid cuz earnings growth can easily change the number of year it will take etc. or when say a company is in trouble and sells at a low multiple, i look at how many years it takes before it dies.

dcf takes a more holistic view of all future cash flows, and gives  a discount rate for each one. there is larger weight for earlier cash flows, but a co with a faster growing earning potential than the discount rate will have a really good valuation a. while a ****tty investment or cigar butts will have a terminal value far shorter when they ultimately no longer cash flow.

anyways the majority of people use multiples. and hte most common mistake most people do is buy a cheap mutliple stock, when they should actually focus on the stabiltiy of expected future cash flows of the business.

I love my cheese. I got to have my cheddar.

^ Yes, that’s where typically if you’re investing with Buffettesque margins of error you A) are buying mature businesses with stable earnings and B) can safely use cycle adjusted earnings for your base like CAPE or an EBITDA equivalent to get around the one year issue.  I understand that DCF more clearly delineates the cash flows, but analysts get around this with multiples by targeting through cycle multiples or pricing a multiple off of a more indicative year then discounting back.  It’s not really a big issue, but ultimately, I think both methods are very interchangeable based on what you’re comfortable with / find intuitive.  If you’re modeling you’re definitely making a ton of small assumptions (and some not small ones) and on multiples you tend to sort of aggregate those assumptions, regardless I think you wind up in similar positions if both are done responsibly.

If you’re arriving at very different outcomes with each method, one is probably not being applied correctly or your assumptions are not consistent.

#FreeCVM #FreeTurd #2007-2017