No. of Recommendations: 15
Overall, I think the framework is clear and practical. I just wonder if softening the contrast with DCF slightly might make it even stronger.Thank you Ears, I have made that part a little softer and added some nuances, which I have published later under the 'All Boards' page.
The DCF calculation is theoretically ideal, or foundational as you write, as a dollar today is worth more than a dollar tomorrow. But practically, the method is close to a dud. The trouble is that the Discount Rate that is applied, and which varies between companies accoprding to their 'risk', allows you to arrive at almost any number for the intrinsic value. The central problem is that really valubale the work that goes into (1) the future earnings predictions (what really matters) can be overwhelmed by the (2) massive effect of the varying discount rates.
Indeed with the approach I frequently use:
Value 'owned' 10 years away (IV10) = (earnings after 10 years) x (10th year terminal multiple) + (aggregate dividends)
or less commonly:
Value 'owned' 10 years away (IV10) = (book value today) x (conservative growth rate)^10 x (10th year termination multiple)+ (aggregate dividends)
.. you are still dealing with 2 variables - trying to come up with an earnings per share (or book value) figure 10 years into future (for the very few firms that have such predicatable earnings), plus on top of that you have to separately deal with coming up with a realistic earnigns multiple at that point in time. If you expect growth to continue from year 10 into year 20, you'll apply a healthy multiple at year 10. So indeed that gives you two variables to work with - the EPS after 10 years, and the multiple applied to that EPS in the 10th year.
However working with the EPS in the 10th year can
inadvertently force you think more critically about the realistic strength of economic moat and thus dismissing many investments that, by only thinking a few years ahead, you would otherwise just apply 'blind hope' for the long-term whilst narrowing your prediction to the short-term, thus including more investments that you would otherwise have dismissed. You may think to yourself with the IV10 approach as follows: "It is a fantasy to come up with earnigns 10 years into the future" - and
there itself lies the strength of this approach - you are 'forced' to decide if the business is sufficiently predicatable and/or durable, thus dropping out of investments that are just too unpredictable.
With DCF, however, you can start to turn into a spreadsheet master, and just apply a higher discount rate as a replacement for your lack of understanding of how the business will fathom in the future, and meanwhile you apply some huge growth for a good story unfolding - so your
mental process becomes that of number games, rather than realistic econoimc-moat appraisal and the sheer dismissal of the vast majority of businesses as realiable investments.
This gets close to the methods I wrote about in the 2016 Manlobbi's Descent book, whilst the 10-chapter intro to investment recently published just at shrewdm.com was aimed at young investors getting started - with just a 'flavour' for how to think about individual stock selection. It was a little coloured, but the goal was to present the larger picture well and motivate young readers to feel some joy and sense of purpose, and act early.
- Manlobbi
