Back to Drew's Views
December 11, 2019
Previous
Next

The DCF is the Randy Watson of Valuation

Stock Picking
Valuation
DCFs 1.JPG

I’m not very well-rounded.  I studied finance in college, and finance in business school.  And man could I turn out a perfect DCF.  I could make that model sing.  After joining Fidelity, I remember ramping up on my first sector, and after finishing, I showed one of the senior analysts my fancy-schmancy DCFs.

“Drew, what in the hell are you doing?”

I was crushed.  Here I had been staying up all night for weeks modelling every aspect of the P&L, cash flow statement, and balance sheet over the next 15 years (for all of my companies) - arriving at what must be the fair value of the stock - and this very smart, well-accomplished, senior guy (hi Sanjeev) basically tells me I am an idiot. [i]

Now, you have a choice here to react as I did initially.  You can think to yourself “oh, he only said that because he knows you won’t have time to do all that work” or “yeah, big institutional shops don’t do proper analysis” or “he just knows the PMs won’t have time to review your model and won’t be able to build any conviction in your ideas.”  Sure, some of those points may be true at some shops, but I finally figured out the bigger picture:

DCFs don’t work because they are laced with bias.

Don’t get me wrong, the DCF is the answer to the “what is it worth” question.  The DCF is perfect that way.  But the DCF is both good and terrible.  We are humans, humans build DCFs, and we have biases.   These biases manifest in the DCF, which itself is full of more moving parts than a steam locomotive.  If we get just one of those parts wrong, the error can compound on itself, and before we know it, our thesis has derailed.

If we have an inkling of excitement about a company or a management team (or indeed, an inkling of resentment), then the DCF is the ultimate camouflage machine; burying our biases and emotion behind annual changes in working capital and terminal growth rates.   As I mention above, I could make a DCF model sing; in fact, I could make it sing any tune I subconsciously wanted it to sing.

And even if we do it objectively (as I am sure nearly all of you DCFers think you are) we are only answering the value question.  The DCF doesn’t care about Mr. Market.  I suppose for some that has its advantages, but not for us.  We are public market investors.  We want to seize on opportunities where Mr. Market is making a mistake of overreaction or underreaction that will fix itself anytime within the next three years.  The DCF doesn’t help us do that.  

Additionally, to the creator of the DCF, it can never be wrong, and that is dangerous.  The commander of a DCF sits in the captain’s chair, presses auto-pilot, puts on the blindfolds, and falls asleep, hoping to wake up at the right destination.  Our view is in some cases, that blindfolded DCF captain leads us straight into the Bermuda Triangle of overconfidence, confirmation bias, and value traps.

Of course there is bias in any valuation methodology, and this will be controversial, but we contend that – because of these points above – a forward (not trailing, for goodness sakes) fundamental multiple (e.g. P/E, EV/EBITDA) or an SoP model may sometimes be a better proxy for an honest DCF valuation than a DCF is itself. [1]

DCFs2.png
I believe DCFs are the future, model well, and let them lead the way…

And if the stock performs well over the long term, it will be because the company beat fundamental expectations.  That’s it.  

Moreover, and finally, the DCF can be just as inappropriate for the high flyers as it is for the potential value traps.  

In 2007, the most offensive, egregiously wild Amazon bull estimated that 13 years from then (in 2020) Amazon was going to print nearly $40 billion of revenues. [2]  

Today, 12 years later, the average sell-side analyst thinks Amazon will do over $320 billion of revenues in 2020.  

Amazon has been a great stock, and a big winner for the bulls; but not because some analyst and his or her DCF figured all this out 12 years ago.  Amazon won because they crushed expectations.

On the other end of the spectrum, potential value traps end up not becoming value traps because they turned the fundamentals around.  They started beating expectations.  The narrative changed.  

Fundamentals matter.  Narratives matter.  DCFs don’t help with either, and can lead us astray in our pursuit of the truth - or at least the truth in all of our time horizons.


Subscribe and sign up with your email address to receive the latest news and updates
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

FOOTNOTES

[i] Coming To America (1988), Paramount Pictures, Eddie Murphy Productions

[1] We’re also aware that there are countless problems with metrics such as EBITDA and earnings as well, including manipulation of these figures, and general problems with accounting metrics vs their true economic value – but we have those problems with DCFs as well.

[2] https://www.albertbridgecapital.com/drews-view-archive/2017/11/9/secular-winners-and-value-investing

Download PDF

Topics

Stock Picking
Valuation

DISCLAIMER

The views and opinions expressed in this post are those of the post’s author and do not necessarily reflect the views of Albert Bridge Capital, or its affiliates. This post has been provided solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The author makes no representations as to the accuracy or completeness of any information in this post or found by following any link in this post.

‍

YOU MIGHT ALSO LIKE

Text Link

Heading

Lorem ipsum dolor sit amet, consectetur adipiscing elit. Suspendisse varius enim in eros elementum tristique. Duis cursus, mi quis viverra ornare, eros dolor interdum nulla, ut commodo diam libero vitae erat. Aenean faucibus nibh et justo cursus id rutrum lorem imperdiet. Nunc ut sem vitae risus tristique posuere.

Text Link
Text Link

Hedge Fund Investing, Turnover, and Taxes

For taxable investors, the impact of taxes on long term post-tax returns really, really matters. But how much exactly do they matter? What sort of outperformance does one of your managers need to generate to offset the penalty of not buying and holding forever?

Portfolio Management
Stock Picking
Read More
Text Link

Stock Market History, Illuminated, 2022 Style

I’ve been keeping a graphic of the long-term performance of the US stock market for many years now, and I’ve been sharing this information in the histogram below. I think it does a reasonable job of revealing how long-term returns are manufactured and the tilts over time. I’ve color-chunked the data by decade to highlight decades of historical weakness as well as periods of strength. I’ve also added additional tables and charts which I think are interesting, and in some cases, stunning.

Asset Pricing
Factors
Markets
Valuation
Read More
Text Link

What Stands in the Way Becomes the Way

I don’t think that Aurelius, Frost or Zweig would disagree that the road less traveled might have a little more alpha in it.

Markets
Behavioural Finance
Stock Picking
Read More
Text Link

Interest Rates and Growth Stocks

It's very possible, if not likely, that the move in growth stocks from 2017 through 2020 probably wasn’t caused or justified by a move in interest rates, but that people believed, and acted like, it was.

Asset Pricing
Factors
Behavioural Finance
Valuation
Read More
Text Link

For Investors, a "Never-Sell" Mantra is a Song for Fools

On the misleading claims of Hendrik Bessembinder about diversification; and the convenient, post-hoc, and the spurious conclusion to always buy and hold.

Asset Pricing
Markets
Portfolio Management
Stock Picking
Read More
Text Link

On the Disincentives of Investing in Public vs. Private Equity; and Implications for Pricing and Returns

Just as the public markets can be affected by short term flows, is it possible that private market valuations, and the periodic marks of particular private investments, have been affected by increasing allocation tilts toward private equity?

Markets
Valuation
Read More
Navigations
HomeTeamDrew's viewsPressContact
Disclaimers
Legal & regulatoryPrivacy policyCookies policy
How to get in Touch
info@albertbridgecapital.com

Subscribe to Drew's Views

No spam. Unsubscribe anytime.
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
© Albert Bridge Capital 2022
Website by SW10media.com
homeTeamdrew's viewspressCOntactDisclaimers