We have written about the pitfalls of using price to earnings (PE) multiples as a valuation tool in our blogs and newsletters. The alternative we use, the Discounted Cash Flow (DCF) model isn’t devoid of shortcomings either – such as the futility in forecasting inherently hard-to-predict long term cashflows or the sensitivity to a somewhat abstract concept of discount rates. However, the proponents of the DCF model do see the merits in it as a tool to improve our understanding of the value drivers or as Michael Mauboussin has shown us the usefulness of DCF in understanding what expectations are embedded in the stock price. Even then, the discount rate poses its challenges. This piece helps throws some light on how we can make sense of it despite its limitations.

“One of the key questions for any discounted cash flow analysis is whether to embed uncertainty into the discount rate or to do so when estimating the fundamentals. There are arguments for both styles:

An optimistic fundamental model coupled with a high discount rate basically says “This is a risky proposition, so I’m demanding a high return because it probably won’t work out.”

A more pessimistic model—say, one that splits the difference between “revenue will triple in the next three years” and “revenue goes to zero in three years because they’re bankrupt” might just plug in 150% total revenue growth over that period. Since the fundamental model already includes the uncertainty, the required rate of return is lower.

But really, these are the same process expressed different ways: to get internally-consistent numbers, you might solve for a valuation in the second case at, say, a 9% discount rate (i.e. at current long-term rates plus the historical US equity risk premium of 5%), you’d then tweak your discount rate for the first valuation until it got to the same output. You want your valuation to be sensitive to meaningful inputs, like the probability that a business works out well and the cash flows it could get in that case. You don’t want the valuation to be sensitive to how you phrase this process to yourself.

Where does that 9% rate come from? The idea of a discount rate is that it’s some kind of fair-market value for the risk you’re taking. You can calculate an ex ante long-term risk premium by looking at the relative performance of equities and bonds over long periods. You can also calculate it ex ante by looking at long-term growth rates in dividends per share, and at current dividend yields.

… DCFs are a research tool. They’re a way to ask what return is plausible given a set of fundamental assumptions, or, equivalently, what fundamental developments would be necessary to reach a particular return. The best ideas are obvious, to the point that arbitrary precision (“do we discount at 9% or 8.5%?”) is pointless if it means the difference between saying something is trading at half of what it should be versus trading at a 53% discount to fair value instead. The value is in the process: the majority of the time something looks cheap, it looks that way for a reason, and building a model of when the cash flows arrive, how that happens, and what they’re worth when they get there is the only way to test this.”

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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.

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