Brett Caughran @FundamentEdge:
I'll give you my 2 cents...
The DCF is paradoxically both a deeply flawed valuation methodology...and the only true methodology for valuation that we have.
The classic DCF approach to valuation an asset is to forecast 10 years of cash flows then apply a terminal multiple.
Andy Constan @dampedspring:
Boosting. Help him fam
twitter.com/kust1983/status/1589323915083780096
Brett Caughran @FundamentEdge:
It seems so straightforward & knowable, right? Wrong. If you crack the DCF for a typical 15-25x P/E stock, you see how truly imprecise the DCF is.
First, the DCF is highly reliant on a LONG duration view on FCFs. At NFLX, only 39% of the current embedded Enterprise Value is
Brett Caughran @FundamentEdge:
ascribed to the next 10 years of FCFs. 61% is ascribed to the FCF's beyond 10 years. And who knows what NFLX will look like in 2032 to 2052!!! But, implicitly, when you conduct a DCF on NFLX, that is the bet you are making (whether you explicitly model 30 years of FCFs like I
Brett Caughran @FundamentEdge:
like to do, or whether you assign a multiple, which is just a shorthand for the year by year modeling).
Second, CAPM and WACC are truly poor tools. CAMP is a one factor model that essentially states that forward equity returns should be dictated by one factor, and one factor
Brett Caughran @FundamentEdge:
alone - Beta (a stocks co-movement with the market). This is truly a stupid framework, and empirically just so incorrect. It saddens me we still teach finance students this incredibly stupid framework. In reality, value, momentum, quality, and betting against beta tend to be more
Brett Caughran @FundamentEdge:
quantitatively accurate factors in determining likely prospective returns.
Now let's pick on the Academic view of always embedding a 5% ERP. That is absurd as well, akin to saying the markets should and do always trade at 18x P/E, which we know they don't.
Lastly, we have to
Brett Caughran @FundamentEdge:
make a bet on the risk free rate in WACC, and where do we even start on a yield curve distorted by the Fed?
So we have three really terrible, horrible assumptions that bleed into a DCF approach, 1) the notion we can predict 30+ years of cash flows, 2) CAPM, 3) WACC.
Brett Caughran @FundamentEdge:
For these reasons, in my 14 years as a professional investor, I've not once heard a pitch that was predicated on a precise DCF value (outside of early stage biotech).
So there must be a better way, right? Scrap the DCF, let's use multiples.
The problem with multiples is that a
Brett Caughran @FundamentEdge:
P/E ratio is just another way to state a DCF. Run a DCF, then state that value as a price ratio over the next year's earnings. You deal with the same challenges. (this is the foundation of @mjmauboussin stating "everything is a DCF").
Inescapably, the present value of any asset
Brett Caughran @FundamentEdge:
MUST be derived from expectations of forward cash flows. And so while DCF is a HIHGLY flawed tool in practice, the framework is as close to financial law as we have.
The advice I give to students learning valuation is this. Learn the DCF framework deeply, then learn it's flaws.
Brett Caughran @FundamentEdge:
But then learn what really influences valuation. Business momentum & the extrapolative bias of markets, estimate revisions, sentiment, capital flows, and cycles of greed, fear & animal spirits.
Brett Caughran @FundamentEdge:
If CAPM was correct, stocks would look & feel more like a bond as CAPM is effectively a concept analogous to YTM for a bond. But that's clearly not the case.
So stock pickers, in my opinion, should learn the tools, learn the flaws, then learn the ingredients of a idea
Brett Caughran @FundamentEdge:
that works in the real world. Learn to arbitrage the market's bias to overreact to inflections, for example.
I use a current state FEV (fundamentals, expectations, valuation) approach. I assume when fundamentals are weak & expectations are low, the embedded DCF view will be low
Brett Caughran @FundamentEdge:
And when those fundamentals improve & expectations rise, the embedded DCF view will increase. So the DCF framework is an important start, but a pragmatic framework of how markets ACTUALLY behave, is critical to actually using the DCF tools.
Brett Caughran @FundamentEdge:
In terms of books, I would recommend the McKinsey Valuation book as it is as close to what I would consider a mathematical proof on value is created in businesses as exists, and @mjmauboussin Expectations Investing that gets the concept right that what matters most is the