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Wow. I'm very impressed with the conversation over the past 24 hours and regret not jumping in sooner. Kudos to Snoop and HR (and others) for some solid thinking. When two of the smartest guys in the house are calling me on the carpet, I have to assume that I'm either wrong about something, or not effectively communicating. I'll entertain the latter for a moment, though I'm willing to accept the former.

A few issues:

1. On the value of Graham's equation - HowardRoark rightly points out that the equation is a shortcut. My guess, having never spoken to him personally, is that Graham offered it in an attempt to simplify the complex. Whether the endeavor of simplifying the complex is a good one or not is up to you. What I DO know for sure is that having this tool in your belt would have kept you away from companies like Cisco, Yahoo! and JDS Uniphase when they were going crazy. In that regard, it has its utility.

2. On the issue of DCF being problematic - I don't think I explained myself very well on this. Let me try again. I am a firm believer that the value of an investment is all of the future cash flows + the terminal value. In order to decide whether or not the investment is currently priced attractively, you apply a discount rate to those future cash flows and arrive at net present value. I'm in total agreement with that.

I also recognize that the person that picks the correct discount rate wins. I guess the problem I'm trying to get at is one of moral hazard, for lack of a better descriptor. By default, the higher your required rate of return (based on your assessment of the underlying stability and predictability of the cash flows), the less likely it is that you'll ever actually realize those cash flows, assuming you're able to acquire the asset.

The challenge is no longer focused on choosing an appropriate discount rate, but more on judging whether the firm's future cash flows are predictable or stable. Because those two are so intricately tied (choosing your discount rate and judging the stability/predictability of future cash flows), it makes it almost impossible to ever pull the trigger. Let me give a mythical example:

Let's say XYZ Corp is just an OK business with cash flows that used to be fairly predictable, but because of business conditions have now deteriorated somewhat. Because you recogniae that there is less stability, you require a higher rate of return. Let's assume the stock trades at $25. Let's assume that your DCF tells you that the stock needs to trade at $15 to allow for the higher required return you've built in.

Now, it's a two months later and the stock is at $15. Do you pull the trigger, or do you ask yourself, "did this get down to this price because the market is efficient, or because the cash flows are less stable than I thought?" Ooooh, wait, let me run those numbers again with new assumptions.

You see what I'm driving at? (Perhaps not). The real risk is not in assigning the proper discount rate, but in being able to assess the future cash flows which will allow you to assign the proper rate. In many ways it's a nose dive that you don't ever really come out of. And, it's one of the reasons that I like the fact that Buffett doesn't use a risk premium. He just uses the risk free rate and then requires that the asset trade at a significant discount to his valuation without the risk premium. Of course, the same problems remain, but they are numerically less complicated.

I feel like I'm talking in circles even though I don't intend to. Let me know your thoughts.


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