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Some investors perform discounted cash flow analyses when trying to assess a company’s outlook. Perhaps these calculations help them justify their investment decisions.
I, however, get absolutely no value from performing these calculations and came to this realization in the mid-1980s while attending a Master of Business Administration (MBA) program at university. My finance professors espoused the gospel of discounted cash flow (DCF) analyses as one of the preferred valuation methodologies for all cash flow-generating assets.
I initially took their teachings at face value. Very quickly, however, I realized that DCF calculations were of little value to me when trying to determine if a company was a suitable long-term investment. I, therefore, merely learned how to use the model so I could pass my Finance courses.
What Is The DCF Formula?
The discounted cash flow (DCF) formula is a theoretical way of estimating the present value of an asset based on its stream of future cash flows.
The formula requires several assumptions of a company's current and future available cash. This available cash is, designated as Free Cash Flow (FCF) determined as operating profit, depreciation, and amortization, minus capital and operational expenses and taxes.
These annual projections are then discounted using the company's weighted average cost of capital to obtain a current value estimate of the company's future growth; the model relies on the concept of the time value of money, whereby a dollar paid in the future is less valuable than a dollar today.
DCF Pitfalls
DCF relies on future assumptions about growth and discount rates. Make different assumptions to your metrics and you get wildly different results!
In addition to being less useful for short-term and speculative investments, the DCF has the following pitfalls.
Operating Cash Flow (OCF) Projections
The most important factor in calculating the DCF value of a stock is estimating a company’s potential future cash flows.
Cash flow projections are often based largely on results for the preceding years. Small, erroneous assumptions in the first couple of years of a model can amplify variances in operating cash flow projections in the later years of the model.
DCF models, however, often use 5 - 10 years' worth of estimates. Accurately forecasting earnings and cash flow this far into the future is debatable.
CAPEX Projections
FCF projections involve projecting CAPEX for each model year. As with OCF, the degree of uncertainty increases with each additional year in the model.
CAPEX can also be largely discretionary. Some highly capital intensive companies have mandatory CAPEX just to remain in business. Less capital intensive industries may be able to rein in or increase CAPEX plans depend on business conditions.
Discount Rate and Growth Rate Assumptions
There are different ways to approach the discount rate in an equity DCF model. Some are very theoretical and may not work well in real-world investing applications.
Some investors use an arbitrary standard hurdle rate to evaluate all equity investments. This way, all investments are evaluated against each other on the same footing.
Perhaps the biggest problem with growth rate assumptions is when they are used as a perpetual growth rate assumption. Holding a growth rate in perpetuity is highly theoretical. A company's growth rate can sometimes change dramatically over time.
The sensitivity of the DCF model means small changes in the discount rate and the growth rate assumptions can lead to very different results.
Elaborate Calculation
Interestingly, two of the world’s great investors (Warren Buffett and Charlie Munger) have never used the DCF model. Although they try to look at a business in terms of what kind of cash it can produce, they want the decision to be so obvious that it does not require a detailed calculation.
At one of Berkshire Hathaway’s Annual General Meetings, Charlie Munger stated:
I’ve never seen him (Buffett) do one (DCF).
Buffett followed Munger’s quip stating that the need to use the DCF to determine if a company is a decent investment suggests investors should likely ‘move on’.
A World of Change
It is virtually impossible to accurately predict how a company is going to perform in the future.
Secondly, a DCF analysis does not typically account for major future acquisitions/divestitures.
Furthermore, a company’s best laid plans can be upended by unforeseen events.
I strongly suspect that few, if any, DCF calculations performed in 2019 took into consideration the onset of COVID in 2020.
How many DCF calculations performed in 2024 took into consideration the introduction of tariffs by the new US Federal government?
Investors who spent a considerable amount of time performing DCF calculations in 2019 and 2024 essentially wasted their time.
How I Determine a Company’s Valuation
My approach to determining a company’s valuation is fairly rudimentary.
I look at management’s current fiscal year’s earnings guidance and try to estimate earnings only for the next fiscal year.
In addition, I look at analysts’ earnings estimates for the current and next fiscal years. Any earnings estimates beyond this timeframe are taken ‘with a grain of salt’.
When there is a significant disparity in analysts’ earnings estimates, I look at how recent are the estimates. On occasion, some earnings estimates are outdated.
In addition, I try to determine the potential impact on future results when a company announces a major acquisition or divestiture.
A company can obscure the true state of its earnings through a variety of methods (eg. recognizing revenue too early, deferring expenses, or using complex financial instruments). I, therefore, find Operating Cash Flow (OCF) and FCF to be superior metrics by which to estimate a company’s valuation but both can be subject to distortion.
In several recent posts, I incorporate ‘conventional’ and ‘modified’ FCF calculations to determine a company’s valuation.
FCF is a non-GAAP metric, and therefore, there is no standardization in its calculation.
Most companies deduct capital expenditures (CAPEX) from OCF to arrive at FCF. I, however, perform a ‘modified’ calculation in which I deduct Share Based Compensation (SBC) from OCF.
Let’s assume Company X decides to partially compensate its employees with SBC.
On the Consolidated Statement of Cash Flows, it will add back 100% of its SBC to arrive at OCF because SBC is not a cash outlay.
Were Company X to award no SBC, it may compensate its employees through higher wages/salaries.
In the first example, Company X adds back the SBC to arrive at its net cash generated from operations. In the second example, it adds nothing back because it actually disburses cash.
We see that merely changing the manner in which a company compensates its employees impacts FCF.
Arguably, Company X is receiving a form of ‘financing’ from its employees when it issues shares in lieu of a corresponding cash outlay. Perhaps SBC should be a component of Cash Flows from Financing Activities on the Consolidated Statements of Cash Flows. If this were the case, SBC would have no bearing on OCF or FCF.
How I Value Asset Managers
Blackstone (BX), Brookfield Corporation (BN.to), and Brookfield Asset Management (BAM.to) are amongst my top 20 holdings.
GAAP earnings and OCF and FCF are not relevant metrics when analyzing such companies; I touch upon this in prior posts.
BX discloses several operating metrics and financial measures that are calculated and presented on the basis of methodologies other than in accordance with generally accepted accounting principles. These metrics are defined at the end of every quarterly Press Release and Presentation that are accessible here.
BN.to and BAM.to primarily measure operating performance using distributable earnings (‘DE’) for its Asset Management and Wealth Solutions segments. Net operating income (‘NOI’) is the key performance metric for the Real Estate segment, and Funds from Operations (‘FFO’) is used for other operating segments. The metrics primarily used to measure performance are accessible in every quarterly report.
The nature of their business is that quarterly results are highly susceptible to fluctuation. In deciding to invest in these companies, I take the view that highly sophisticated sovereign wealth funds and institutional investors are entrusting these companies to invest funds on their behalf to generate attractive long-term investment returns. I am, essentially, ‘following the money’.
Final Thoughts
As an increasing number of investors focus on cash flow as opposed to earnings, the DCF analysis has increased in popularity.
While the value of a company is related to the present value of the future stream of FCF, I have no confidence in my ability to select appropriate input values for this model.
It may be easier to forecast future performance of some companies than others. Sometimes, however, even relatively predictable businesses make a major acquisition/divestiture and encounter unforeseen major economic disruptions. This is why performing DCF analyses for relatively stable businesses are a waste of time.
I am not about to start wasting my time performing DCF analyses and take comfort that Buffett and Munger do not use this model.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.
