Does Discounted Cash Flow Always Work?

August 24, 2007 by Joe Ponzio

Interestingly enough, quick asked a question that was going to be the topic for today. When does the discounted cash flow model work? When does it not? Is this a method that can be used for all businesses at all times?

The short answer is: The discounted cash flow method always works for valuing a business. But, I’m not known for short answers, so let’s explore the weaknesses in this model. Considering that my spreadsheets have been taken, used, and modified around the web, I think I should qualify a few of the assumptions in there.

Margin Of Error Safety

In order to calculate the intrinsic value of a business, you need to predict, with a degree of certainty, the future owner earnings of that business. You don’t have to be precisely correct, so long as you are not completely wrong. To protect yourself from error, you need to buy at substantial discounts.

Example: If you predict that owner earnings will grow at 14% for ten years, and it only grows at 9%, you should still make money. Why? Margin Of Safety. Johnson & Johnson has a market cap of $193 billion which means the stock market does not believe that Johnson & Johnson’s business is more than that.

At what rate would Johnson & Johnson have to grow in order to be worth $192 billion today? About 4%. Any higher and Johnson & Johnson is underpriced; lower and it is overpriced today.

Predicting The Future With Certainty

In order for your discounted cash flow model to work, you need to be able to reasonably predict the future owner earnings, regardless of the past. That also goes back to my Amylin analysis. I got quite a bit of hate mail from that, but here’s why I don’t like it for me-or for most investors:

At this point, it is nearly impossible to predict the future owner earnings of that (or any) business that has never generated any. There is, in my opinion, no way to know how Amylin will turn revenues into cash for us silent partners. Because of that, there is no way to know if Amylin is, in fact, a $6 billion company.

For any discounted cash flow model to work, you need to have solid reasoning and data. Simple, predictable, established businesses offer that; the “next hot stock” usually doesn’t.

The Discount Rate and What It Means

Your discount rate affects everything-from your margin of safety to your future expectations. Buffett has said:

Don’t use different discount rates for different businesses…it doesn’t really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows.

If you are using a 15% discount rate, understand that you’ll end up with lower valuations and will need to accept a smaller margin of safety (25% vs. 50%). Why? Look at the Coca-Cola example from 1988. At that time, with a 15% discount rate, Coca-Cola was valued at $59 a share. Had Buffett tried to use a 15% discount rate and a 50% margin of safety, he would have never bought Coca-Cola because it never hit $29.50 a share in 1988 or 1989.

Using a lower rate-8.85%, the 10-Yr. treasury-Coca-Cola’s value in 1988 would have been closer to $91 a share. With a 50% Margin of Safety, Coca-Cola was attractive at Buffett’s purchase price around and under $45 a share.

Consistency

It may not always be practical to assume that the future owner earnings will grow at exactly one rate for ten years, then exactly another rate for the next ten. As I’ve said before, there is an art to investing…not just the science of the spreadsheet.

You don’t have to predict the future with bulls eye precision; still, some businesses will certainly not be able to grow consistently for ten years before they level off. Some companies may only have five years left before growth slows; some may go on for much longer than ten years.

If you’re not sure how long the business has left, pass. You can make gobs of money in simple, giant companies.

You Don’t Need High Risk For High Returns

It is in our nature to look (or hope) for the next undiscovered Microsoft, but we don’t need to. You can make gobs of money in slow-growing, boring businesses. It all depends on your purchase price and how long it takes for the stock market to bring the price up to the business’ intrinsic value.

If a business is valued at $100 a share but its stock is $50 a share, here’s how your money would grow based on a 5% growth in the business and the time it took for the market to finally price the business back to its intrinsic value:

Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10
Intrinsic Value $ 105 $ 110 $ 116 $ 122 $ 128 $ 134 $ 141 $ 148 $ 155 $ 163
Annual Return 110% 48% 32% 25% 21% 18% 16% 15% 13% 13%

Once the difference between price and value gets too wide (beyond 25% to 50%), it often takes two or three years for that gap to close again. Still, if it took seven years, you probably wouldn’t be too upset with a 16% average annual return and little risk.

There Is More Than One Way To Skin A Business

Next week I’ll compare a few different methods for valuing businesses. Which is the best? As you’ll see, some will make absolutely no sense except that they’ve been backtested well, some can be used for trading stocks, and some will bring you to exactly the same conclusions as F Wall Street.

In the end, it all depends on what you want out of your portfolio. Me? I like high returns with low risk, little excitement, and low maintenance. I’m not much of a gambler…except in Vegas.

So, quick, to answer your question: Is your business predictable, consistent, and sporting a moat and large margin of safety? Do you want to find the value, ignore the markets, and wait for the price to catch up to the intrinsic value? If yes, yes, yes, yes, etc, then you can use the discounted cash flow model on TGT.

A Note From Joe Ponzio

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