In yesterday’s newsletter I outlined James Montier’s objections to the practical use of the simplistic textbook version of discounted cash flow analysis (in his book Value Investing). Today I’ll describe his suggested alternatives.
Reverse-engineered discounted cash flow
Take the current share price and use the DCF formula to work out what is currently being implied by the market.
The resulting implied growth estimate can be considered by the analyst bringing in other factors to gain perspective. This assessment is likely to include comparison with the range of growth estimates companies generally, or this particular company, have achieved in the past.
For example, assuming a share is trading at £2.33 offering a cash flow (all paid out to shareholders) next year of 7p per share, and that the required rate of return of 8% per year for this risk class of share:
P = next year’s CF/(required return – growth rate)
233p = 7p/(0.08 – X)
X, growth = 0.05 or 5%
Now think through whether 5% is a reasonable expectation in light of the company’s competitive position, industry growth rate and past cash flow growth rates.
Problem: this approach “solves the problem of not being able to forecast the future, but it doesn’t tackle the discount rate problems outlined [in yesterday’s newsletter]”
Advantage: it provides some anchor for reasonable growth expectations. Montier says “I have seen analysts return from company meetings raving about the management and working themselves into a lather over the buying opportunity this stock represents. They then proceed to create a DCF that fulfils the requirements of a buy recommendation (i.e. 15% upside, say). They have effectively become anchored to the current price. When a reverse-engineered DCF is deployed this obsession with the current price is removed, as the discussion now takes place in terms of growth potential.”
Benjamin Graham offered two ways of approaching valuation. The first is asset based, with a particular focus on the liquidation value.
“The first rule in calculating value is that the liabilities are real but the assets are of questionable value” (Graham)
So, following Graham's net current asset value approach, you’ve seen me many times looking at UK companies’ balance sheets and deducting one-fifth of receivables and one-third of inventories because the managers may have been over-optimistic. In addition most non-current assets are valued at zero. The main exception is freehold or long-term leasehold property (Graham devalued this to only 15% of its BS estimate, but in most macroeconomic conditions I’m prepared to accept current market value – which can be more than shown on the BS)
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