Three Longs & Three Shorts

Everything Is a DCF Model

Author: Michael J. Mauboussin, Dan Callahan, CFA
Source: Morgan Stanley(

The value of a business lies in the cashflows it generates over its life, adjusted for time value or what is called the Discounted Cashflow (DCF). Yet, majority of market participants don’t use it for reasons ranging from the frivolous to somewhat valid. In this article, Michael Mauboussin and his colleague Dan Callahan at Morgan Stanley try address the somewhat valid reasons and show why even in each of those cases, we are better off using a DCF.
“…an investor, from a venture capitalist to a manager with a portfolio of large-capitalization stocks, owns partial stakes in businesses. The value of those businesses is the present value of the cash they can distribute to their owners. This suggests a mindset that is very different from that of a speculator, who buys a stock in anticipation that it will go up without reference to its value. Investors and speculators have always coexisted in markets, and the behavior of many market participants is a blend of the two. But it is useful to keep in mind that these are separate activities. Note, too, that “everything is a DCF model” does not apply to assets that do not generate cash flows, including cryptocurrencies, art, wine, and gold. All of these assets may be of value and many of them have appreciated over time, but they are not subject to what John Burr Williams, an economist and author of the 1938 classic book The Theory of Investment Value, called “evaluation by the rule of present worth.”
…The topic deserves attention because many market participants now, as in the past, don’t think that DCF models are relevant. High valuations for many startups and companies with negative earnings, as well as the existence of “meme stocks,” where gains and losses are determined more by online forums than fundamentals, make thinking about cash flows appear quaint. Further, many practitioners use heuristics for value without recognizing the purpose and limitations of the shorthands. At the end of the day, the intrinsic value, determined by the present value of future cash flows, attracts the price like a magnetic force. This means that investors always have to keep in mind the value drivers of a discounted cash flow model. It is easy to forget but useful to remember.”
The authors go on to show why none of those excuses hold water such as the one that “small changes in assumptions for a DCF model can lead to large changes in value.” Whilst this is true, the authors argue: “As a result, many investors are more comfortable using multiples of earnings or cash flow as proxies for valuation. Multiples are a shorthand for the valuation process that have the benefit of saving the user time at the cost of buried assumptions. John Burr Williams anticipated concerns about the inputs into a discounted cash flow model. In chapter 15 of his book, called “A Chapter for Skeptics,” he wrote, “. . . the old-fashioned methods of appraisal in reality took cognizance of all the factors which give such intricacy to the new formulas, but the old methods did so implicitly, whereas the new methods do so explicitly.” In other words, valuation using multiples does not avoid the drivers of long-term cash flows but rather obscures them. Williams argues that it is better to make your assumptions explicit and debate them than to make them implicit and ignore them.
Even if you choose not to build a DCF model for every investment you make, it is useful to keep in mind the factors that drive value. These include growth from investments that earn in excess of the cost of capital, the competitive advantage or uniqueness of a business that keeps competitors at bay, and the opportunity cost of capital. You have to earn the right to use a multiple, which happens when you can demonstrate the link between value and the multiple. Another effective way to use the model is to ask what you have to believe about the value drivers to justify today’s price. This approach singlehandedly addresses all of the common concerns about a DCF model. Instead of an investor determining value, he or she needs only to assess whether the expectations embedded in the shares are likely to be met.”
In conclusion they say:
“The value of an asset that produces cash is the present value of the cash flows it generates over its life. Few investors explicitly use a DCF model all the time, but it is useful to keep the drivers of the model in mind constantly. The ideas behind a DCF model have been around for a very long time. Warren Buffett, chairman and chief executive officer of Berkshire Hathaway, suggests they were introduced more than 2,500 years ago:
“ . . . the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.). The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush— and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.” Aesop knew that everything is a DCF model.”