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Hi everyone,

Everyone is probably familiar at least with the concept of a discounted cash flow (DCF) model. Build a model that projects cash flow of some type (earnings, free cash flow, dividends) into the future, discount back to the present by an appropriate discount rate, sum everything up and you have your intrinsic value (IV) for the company. Going through this exercise is really good on the one hand, and can be really bad on the other. Let me elaborate.

Building the model really makes you think about what is the driving force (or forces) behind the business. What does it do? How does it make money? What levers are there to increase the latter? By thinking this through, you get a better understanding of the business. That's important.

However, there are several drawbacks to the model. First, it can lead to a false sense of precision. I've often wondered why analysts give a precise dollar share price in their "price targets." Why $78 and not $80, for instance? The answer probably has to do with what their model is kicking out.

Second, it can give a false sense of understanding. I know this company! If it grows like this and it should, it will be worth that.

Third, there can be a whole bunch of moving parts and assumptions. The more moving parts in a model (why a 28% operating margin instead of 26%? why 10% R&D expense instead of 11%? why change revenue growth by 5% per year instead of 4.2%?), the more chances there are for something to be wrong and the greater the chance that the IV is completely wrong. I'm convinced that the ways for the model to go wrong are not just a sum of the number of variables, but more like some exponential function of the number of variables.

Fourth, the future is inherently unpredictable. We can make estimates for the next year, maybe two, but for five or 10 years? Give me a break! Senior management has plans for the next several years, but I've seen first hand how those plans change as new situations come into being. Yes, the analyst can update the model, but the accuracy is still probably not going to be very good.

Fifth, there's the whole issue of what discount rate to use. Traditional analysis has you building it from the risk-free rate added to a equity premium which is affected by one or more company-specific modifiers (called beta in the CAPM). Riskier investments are supposed to use a higher equity premium (and thus have a higher discount rate), while less risky stocks would use a lower premium. While this is a drawback of the DCF model, it also applies to what I'm doing, so I'll revisit this.

Yet, most analysts, even here at TMF, go through the exercise of building a DCF model, both for the good reason, but also for predicting IV. So, how can I get an advantage?

Well, one way is to not play that game, at least in the calculating IV way. Instead, study the company as necessary for the first part, to understand what makes it tick. Then, using a particular discount rate (DR), use a very simple DCF model to see what kind of growth is expected by the market at today's prices. I've seen this called (and have called it myself) a "reverse DCF" or "upside-down DCF." Let the price predict the growth for the analyst, rather than the analyst predicting the growth for the price.

Finally, compare those growth rates to what the company has shown it is capable of in the past and what it could reasonably expect today and ask, "Is that reasonable?" Not on an absolute level, as in "5% expected growth for the next five years, but 7% is reasonable" but in finding big disparities between what is expected by the price and what the company can likely do.

I'm sure everyone will get tired of the following example, but it illustrates my point exactly. In the spring of 2009, such an analysis with Apple at $90 per share had zero growth baked into the price at a moderate DR of 12%. Look at the company! It was growing sales in the middle of the worst recession we've seen in years. It had new products that were wildly popular and the expectation that it could introduce more products. And the share price showed that the market said, "That doesn't matter." That's a Messed-Up Expectation (MUE).

With RIG, I think I've found another one. In fact, I identified it last summer at about $50 per share, and the expectation was no growth (or possibly negative growth) in free cash flow for the next 10 years, at a fairly high discount rate. I bought for my personal account at that point, and, while I suffered a temporary decline, I'm now sitting on a very happy 23% gain on my entire position since then (bought 3 times). At last Friday's close of $63 and change, there's less than 1% growth in FCF priced in at a 15% DR, and I think that's ridiculously low, for the various reasons outlined in today's article. Thus, the recommendation and tomorrow's purchase (we're purchasing shares in the companies we recommend the day after publishing the buy article).

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