One of the biggest changes in my investing process over the past year has been my increasing usage of discounted cash flow (DCF) models. I used to rarely use them and now I build DCF models for every company I’m serious about. I want to start by reviewing the major things that a lot of investors (including myself) don’t like about DCFs and how I’ve gotten over these concerns.
Too many assumptions
The number of assumptions one has to make to build a DCF model is very large. It’s impossible for me to accurately make fifty different assumptions that determine a company’s future. Doesn’t this mean the final output of the model will be inaccurate and useless? The thing that took me awhile to realize is that slapping a multiple on earnings or cash flow involves the exact same assumptions. The only difference is valuing companies based on multiples makes those assumptions implicit versus a DCF model that forces explicit assumptions. You may not realize it, but slapping a 15x multiple on a stock is absolutely making assumptions about the company’s future growth rate, margin compression or expansion, return on invested capital, debt-to-equity ratios and all the other explicit assumptions in a DCF.
Beta and cost of equity
The traditional way to calculate cost of equity under the capital asset pricing model (CAPM) uses beta, which is probably the dumbest financial concept to ever reach as much mindshare as it has. I used to disregard DCFs because in my eyes they were based on this flawed logic. But cost of equity and weighted average cost of capital (WACC) are extremely important to valuation. A company that earns returns above its cost of capital creates value; a company that earns returns below its cost of capital destroys value. The key for me was to come up with a cost of equity calculation that made sense to me. All cost of equity is trying to calculate is the minimum return an equity investor should demand, which includes beating inflation and getting a premium for being the most junior piece in the capital structure. Dale Wettlaufer at Charlotte Lane Capital had a great write-up last November on how he calculates cost of equity and WACC. My calculation differs only slightly from his. I have a lot more thoughts of WACC, but I’m going to save that for a future post.
Terminal growth rates
Most DCFs have two major components: a period of years (usually 5-15) that are forecasted explicitly and then a terminal value that represents the value of the company thereafter (in perpetuity). Estimating what a company is worth in perpetuity ten years from now is an impossible task and I honestly don’t love any of the popular methods. However, the terminal value often accounts for over 50% of a company’s valuation so it’s very important. I think the best compromise is to use several different methods (with different growth rates) and average them together. Growth rates should approximate expected future inflation and/or expected GDP growth—something in the 3-4% range seems reasonable to me. In the long-term it’s impossible for a company to grow faster than the overall economy.
Buffett doesn’t use them
This was almost certainly part of my aversion to DCFs early in my investing career. While I learned a ton from Buffett when I was starting out, I also came to realize that a lot of what he talks about does not apply to what I’m doing. I also think Buffett contradicts himself a bit when commenting on discounted cash flows:
“To value something, you simply have to take its free cash flows from now until kingdom come and then discount them back to the present using an appropriate discount rate.”
No one is going to disagree with that and that’s precisely what a DCF does, yet he’s against trying to actually calculate those future cash flows:
“If you need to use a computer or calculator to figure it out, you shouldn’t [buy the investment].”
He doesn’t need a computer or calculator because he’s a genius:
“Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind.”
Well, I can’t prepare spreadsheets in my mind, so I’ll stick to Excel.
What changed my mind
If you ask value investors what a company’s fair value is, the vast majority will say something similar to the first Buffett quote above: a company is worth its future free cash flow discounted back to today. Then those same investors (for a long time I was included in this) hate on the one valuation method that explicitly measures future free cash flows. So everyone agrees what a company’s value is based on, but no one values companies based on that. When I first realized that disconnect, it was a bit of an “a-ha” moment for me. This report from Credit Suisse, What Does a Price-Earnings Multiple Mean?, is a great read that compares DCFs to multiples when valuing companies.
I was reading a rather convincing write-up on Value Investors Club recently that used a DCF to value the company. The DCF spit out a very nice upside potential at the end, but I thought the WACC he used seemed low. I plugged in what I thought was a more reasonable WACC and the new per share value was lower than the current share price! I’m not saying I’m right and he’s wrong, my point is that you can make these models output anything you want with (seemingly) small changes. This is one of the major problems with DCFs.
I’ve come to really like DCFs because it forces me to think about every aspect of a business explicitly. When I’m calculating cost of goods ten years into the future, I’m forced to think about the company’s historical cost of goods and how and why it might change in the future. Of course a DCF isn’t required to go through this thought process, but it does ensure I think about every single line item in the financial statements. Even when using DCFs, it’s crucial to remember the limitations and that the basics are still what matter most—competitive advantages, growth opportunity, shareholder friendly management—and these things can’t be described with numbers. And when in doubt, be conservative by using a high discount rate and a low terminal growth rate.