Once upon a time with Discounted Cash Flow (DCF)
DCF and I have been in relationship for more than a decade. When I first met DCF, I was attracted and I must say, quite fascinated by the looks and let me say the overall ‘aura’. We started spending more time together.
Interestingly, everyone around also acknowledged my fascination and that made me believe that it might be the right choice. After few years, I felt DCF is cheating me, it is showing me stuff that I want to see and not the ‘real’ stuff.
History of Discounted Cash Flow
Theory of Investment Value, written over 50 years ago, John Burr Williams described the value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.
Value = Free Cash Flow1/ (1+Discount Rate)1 + Free Cash Flow2 / (1+Discount Rate)2…+ Free Cash Flown/ (1+Discount Rate)n
My finance background taught me to be loyal to Efficient Market Hypothesis (EMH). As a genuine person, I followed the advice. DCF was also attracted to me because I had faith in EMH. I would arrive at cost of equity by using capital asset pricing model (CAPM). My confidence on this approach was so high that I advocated and also taught fresh minds to be loyal too.
During my McKinsey days, I started questioning my faith. However, CFA curriculum further convinced me that ‘the faith must continue’. Few years later, I left corporate life to start my own investment company. I started managing investments instead of making presentation to clients. Often, a minor change in the DCF assumption changed the value of stock exponentially. Something was missing and I wanted to know what.
One of the detectives I identified was ‘Benjamin Graham’. He wrote famous books on investing ‘the intelligent investor’ and ‘security analysis’. Interestingly, there is no mention of DCF in these books.
I knew my love for DCF was pure and few books written decades back could not change my opinion. I hired Ben Graham’s student, who had done reasonably well in investing, Warren Buffet. Mr. Buffet has been sending me letters for the last many years (even before I was born) to help me understand the right way of investing. (https://www.berkshirehathaway.com/letters/letters.html). During this investigation I was also assisted by his partner, Mr. Charlie Munger.
This journey started almost ten years back. I started looking at things with the right perspective. Margin of safety, economic moat and circle of competence became core to my investment philosophy. But I was still not sure whether DCF cheated me or not.
As I continued my search, I hired more detectives and instead of calling them detectives, I started addressing them as ‘Guru’. Bruce Greenwald taught me how to break values without doing hanky panky business with DCF. Whereas James Montier taught me to look at DCF to gauge market consensus. The list of these gurus continued to increase including Howard Marks, Seth Klarman, Peter Lynch and Joel Greenblatt.
Now the fundamental question remains, whether I am still in relationship with DCF or have we parted ways?
We are ‘friends with benefits’ and would like to keep it that way.
I use DCF to understand the growth expectation built into the current price. One of the ways to gauge the market consensus is ‘implied growth’, also called ‘reverse DCF’.
Let’s see this with the help of an example. I have taken Colgate Palmolive for illustrative purposes.
We need to have few variables:
1. Free Cash Flow
2. Discount Rate
Free Cash Flow = Cash from Operations – Capital Expenditure
Colgate Palmolive’s Average Free Cash Flow from 2015-19 = Rs 490 crores
We can use the following guide for discount rates
1. 8% for great business
2. 10% for good business
3. 12-18% for gruesome business.
Predictable cash flows can be discounted at government rate. The current 10-year government bond yield is 6.5%, I have just added 1.5% to that rate just to be little conservative.
Colgate Palmolive is a great business due to its debt free status, stable and predictable cash flows and let’s agree, you don’t really experiment with your oral hygiene. No wonder they have almost 54% market share and people do not prefer switching to other products.
Colgate Palmolive’s Discount rate = 8% for great business
At the end of DCF, we have to apply terminal growth value, we assume terminal growth rate as 4%. Again, no jargons, I expect Colgate Palmolive’s growth to settle down and grow at 4% similar to India's long-term inflation target.
Assuming these variables, we arrive at 17% growth rate based on the current price. This expected growth rate seems to be high.
When we compare the implied growth rate with the last 5-year Free Cash Flow growth, it is almost 25% p.a., so 17% sounds reasonable.
Now, I use DCF to understand whether it’s worth valuing a company or not. Investment decision is based on the Earning Power as taught by Mr. Buffet.
“Be present in the present as the present is the present of the Supreme Presence” – Bhagavad Gita
All the investment gurus for years have been advising against forecasting. They recommend making investment decisions based on the current data and operating within your circle of competence. The only thing about the future you need to answer is whether the business will exist 10/20 years from now.
Investment Mantra - "Predictable businesses with long history available at a reasonable price."
DCF and I are not together anymore, but we still continue to meet and greet, as required.