Issue 111, 06 September 2002
Investor's College Investment equation pt 3 In this, the third part of our series, we look at how discounted cash flows relate to intrinsic value. Last issue we introduced the investment equation and discussed arguably its most important component, capital protection. This time around we’re going to examine the concept of discounting cash flows. After last issue’s article you should understand that the concept of discounting cash flows isn’t hard. The question is how it relates to the intrinsic value of a company and, therefore, its share price? Let’s pretend we knew exactly how much a company was going to earn every year until it ceased operations. We could simply discount those cash flows back to today’s value (using the formula described last issue) and add them up to determine the present value. Future cash Of course, you won’t know exactly what the cash flows will be, although they are easier to predict for some businesses than others. As we said in the last issue’s feature, it’s much easier to estimate what TAB will be earning in five years’ time than it is ERG for example. So the first problem is figuring out the amount of future cash you are going to discount. The second problem concerns the rate at which you will discount it. Academics will tell you that to determine the correct discount rate you should use a fancy formula incorporating the past volatility of the share price, known as the beta. This, they believe, represents the ‘risk’ inherent in a stock, and that you should discount the estimated future cash flows at a higher rate to compensate for that higher risk. Buffett incorporates risk at the other end of the equation. He considers the likely future cash flows and applies a long-term government bond rate to discount them to today’s value. Then, when he has an estimated intrinsic value, he buys the stock only when he can get it at a significant discount to that value. This is what his teacher, Ben Graham, referred to as a ‘margin of safety’. We discussed this concept in issue 109’s feature article and chapter 20 of Graham’s seminal tome, The Intelligent Investor deals with it in detail. The academics try to nail down ‘risk’ through complicated mathematics but Buffett knows better. He doesn’t believe in higher discount rates to compensate for uncertainty. Instead, he doesn’t even think about a stock unless he is confident he knows what it will look like in ten years’ time, which is why he avoided tech stocks. And this is where the argument breaks out between the academics and, arguably, the world’s most successful investor and his partner, Charlie Munger. Munger is even more scornful than Buffett on the topic of modern portfolio theory, saying that much of what is taught in universities today is ‘demented’. Buffett and Munger are not alone. Many successful investors have spoken out against the academics’ definition of risk as being ‘share price volatility’. The practitioners usually argue that it is the business itself that is the source of risk, not perceptions of the company’s progress, which is hat share price fluctuations represent. But back to intrinsic value. As we said earlier, Buffett uses the long-term government bond rate to determine intrinsic value. But he has also stated that when interest rates are at abnormally low levels he uses a modest rate of, say, six or seven percent rather than a lower figure. With US interest rates around 5% and domestic rates about 5.6%, we’re inclined to agree. You can experiment yourself, using the formula from last issue, to see what effect a lower discount rate has on the present value of future cash flows. This exercise will also demonstrate to you the importance of changes in interest rates on the value of all your investments. It’s the one factor that cuts across all financial markets, affecting the intrinsic value of everything from your share portfolio to your house. Agreement So, although there’s agreement on the big picture notion of discounting cash flows, there’s still wide scope for valuations based on different projected cash flows and the application of varying discount rates. And you should bear this in mind if you have the misfortune to read broker reports. They often mention a pinpoint DCF (discounted cash flow) valuation for shares which, in our view, gives a false sense of almost scientific accuracy. Business valuation, which lies at the heart of share investing, is part art, part science. Do it yourself and you’ll see why. For further information on this important topic we suggest you read Buffett’s essay ‘Superinvestors of Graham-and-Doddsville’ in the appendix to recent editions of Graham’s The Intelligent Investor.
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C o p y r i g h t Š 2 0 0 6 The Intelligent Investor . Published by The Intelligent Investor Publishing Pty Ltd. ABN 12 108 915 233. Australian Financial Services Number 282288. PO Box 1158, Bondi Junction NSW 1355. Ph: 1800 620 414 Fax: (02) 9387 8674 WARNING This publication is general information only, which means it does not take into account your investment objectives, financial situation or needs. You should therefore consider whether a particular recommendation is appropriate for your needs before acting on it, seeking advice from a financial adviser or stockbroker if necessary. Not all investments are appropriate for all subscribers.
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