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Author: howardroark Big red star, 1000 posts Top Favorite Fools Feste Award Nominee! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 18386  
Subject: Re: Ben Graham's Equation Date: 10/31/2001 4:47 PM
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I challenge you to show me a single company that's trading at a significant discount to future cash flows where the predictability or even stability of those cash flows isn't in doubt.

Your argument seems to assume a proposition that I question. Namely, that models derive validity by differing from methodologies used by the market. Why would you think that is so? I can create numerous, ad hoc models which will easily provide valuations that differ significantly from market valuations, even given the same forecasts of future company fundamentals. For example, I can simply say that a company is worth the present value of its risk adjusted future cash flows times three. This would satisfy your implicit criteria of creating methodologically-based discrepancies, but of course add no validity to my attempt to value the business. In contrast, I'd argue that the valuation method should be judged by its empirical accuracy, and certainly not by whether it creates buying opportunities by virtue of its own methodology. In fact, I'd argue that the only valid criticism to DCF or any other valuation methodology is that it doesn't robustly model value. So when you say...

The real problem is that the risk you assume has little or nothing to do with running a solid DCF because truly undervalued companies by traditional DCF standards are ONLY undervalued because there is doubt amongst market participants as to whether the future cash flows can remain in tact.

..I am mystified, because I would identify this as the precise goal of a valuation model. That is, firms differ in expected value not because value is as value does, but because the expected future fundamentals of those firms vary. To say that a shortcoming of DCF is that it values all firms the same except for the differences in their expected future results is the ultimate compliment to a valuation model!

Of course, it is possible to argue, as some Real Options proponents do, that DCF is not the empirically superior way to value all firms at all times. Perhaps even a Graham proponent could attempt to argue this point on the basis that, in practice, his method eliminates the human tendency to be overly precise when using theoretically accurate models (a rather weak argument in this case, if you ask me). But the goal should not be for the model, itself to create value or to differ from the market, but rather that it best reflect value.

Philip Morris is a perfect case in point. By all traditional DCF measures, it's been dirt cheap for some time now, and especially last year. The real risk that you took was whether those cash flows would remain in tact. That's where the risk is assumed, at least for most large companies that are widely followed.

It's a myth that there are traditional DCF measures. There are some who would tag MO's cost of equity capital as extremely high due to litigation concerns, which itself could easily explain a DCF value equivalent to recent trading prices. Atlernatively or jointly, a model could simply predict lower future cash flows according to litigation-related predictions, and also create a much lower value. DCF does not mean the past equals the future. DCF means the present equals best expectations.


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