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Hi Mike,

It's a cold, Ontario night, and I'm writing this during play-breaks in a Toronto Maple Leafs/Dallas Stars game, so apologies if it comes off as a little disjointed....

I think DCFs don't work too well in the case of rapidly growing small/mid-cap shares. Tom Gardner has pointed to a couple of reasons why ( on the MPX and QSII boards ):-

Yes and no. The dirty little secret with DCF's is that you can obtain any value you wish to, simply by altering the inputs. In the case of Hewitt's NILE valuation, he's not going terminal 3% until 20 years out. I don't recall his discount rate, but from a present value perspective, 20 years out is not greatly contributing to the overall valuation. (And we'll ignore the fact that it's often a mugs game to forecast beyond a year or two, since errors multiply upon errors).

But DCF's work great in helping you avoid silly investing mistakes with the caveats of: Their use is simply as another (rather powerful) tool in the arsenal, and employing ever-more enthusiastic assumptions in the DCF to justify current or marginally higher stock values is done at the modeler's peril.

The problem with DCFs exhibited very well in 1998-2001, is that people kept on justifying those assumptions higher. I know that you read the exchange between Tom and myself over on the Stock Advisor QSII board, so I'll refer you back to the discussion of CSCO and sustaining high valuations over a long period of time as proxy for justifying QSII's similar high current valuation. Forgetting the crazy years of 1999 and 2000, if you simply go back to CSCO's July 1998 fiscal year-end and measure from there you've made roughly 2% annually for the last 7 years. Why? Because a rich valuation of around 70x FCF for even a 'premium' company such as CSCO was simply too much, even as they delivered (and continue to deliver) stellar returns. You can go back to 1998, 1999, and 2000 and find DCFs showing why CSCO was overvalued at that point in time. You can also go back and find a lot of justifications that "this time is different" and "value is more than a DCF".

Although I know little about NILE, I consider myself (perhaps erroneously) to be very well-versed on QSII. And when I have to assume 35% growth for 7 consecutive years to justify today's price - well then I don't think there's any serious fashion in which I can claim a margin of safety.

Another perspective is to consider the return you're seeking from your investments, and then to consider what your company must do to justify that return. Hewitt does this with his Croesus Test, and I've put together what I call a Reverse Thumbnail. Again, not to highjack a NILE thread, but looking at QSII in this light, assuming you wish to achieve a 15% annual return over the next five years, and that QSII will deserve a 35x P/E, you need to grow earnings nearly 29% per year.

Much like changing your assumptions in a DCF, you can, of course, start to equivocate; saying QSII in 5 years will surely justify a 40x or 50x P/E, or that you'll be satisfied with only an 11% or 12% annual return. But the end point is the same. I see with QSII what I suspect Hewitt sees with NILE; a tremendous company firing on all cylinders, but a company that must have so many things fall right, that there is little potential for market-beating returns from today's share price.


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