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Tuesday 27 July 2021

Discounting DCF - Why DCF fails most of the time in valuing companies

This post was triggered by a valuation of Zomato. It came as a WhatsApp forward and I laughed out loud when I saw it. I have been a skeptic of DCF (discounted cash flow) and a lot of simultaneous thoughts ran through my mind.

The obvious problems of DCF are many. I will list a few of my pet peeves here:

1) Most of the present value is derived from the terminal value - Terminal value assumes that a firm will be in business forever. May not happen in real life. Secondly the growth assumptions of close to GDP growth rate is also fallacious. Who can determine what the GDP growth rate will be in 2040? India's GDP before 1991 was an average of 4% and that of the last 30 years post-liberalisation at about 6%. Excluding the Covid period, it has varied from about 4% to 11%. So, what value should we take for terminal growth. Try changing it from 4% to 11% and see what a difference it makes to the valuation.

2) Arbitrary discount rate and cost of capital - The discount rate applied varies vastly over time and has a large effect on the DFC calculation. People use basic approximations like 10 or 30 year US treasury rates or some such risk-free rate. Again a few percent difference can make a huge difference in the final value, so much so that the entire valuation becomes redundant.

3) False precision bias - The entire process is full of assumptions. And it has to be because it deals with the future and as such cannot deal with any levels of certainty. But a DCF done in an excel gives a double digit precise value. People misunderstand accuracy for precision.

4) World is dynamic and things change - The world is changing all the time. I don't think we need to remind ourselves of that in pandemic times. Like I keep saying no annual report had pandemic as a risk before 2019. So, making revenue, cash flow projections for the next 10 years is not only extremely difficult but, in my mind,foolhardy. People who were valuing Amazon had no clue that AWS would turn out and be as profitable as it has become. Similarly, glance back at DCF valuations done of Nokia in 2005-06 period. You will know what I am saying.

5) Gives a false sense of security - Because you think you have done a valuation, you believe you know what the business is worth. But that does not help you in real life. What do you do if the stock price falls below your calculated value? You buy more? Or sell? What if you buy more and it keeps falling? How long do you buy? What happens if the price goes up 2x-3x-5x from the calculated value? Do you sell because it's overvalued? Do you hold on for more gains? So, you see valuation is just one small part of the whole.

6) It ignores market sentiments - Valuation depends on the sum of all future cash flows and also the "prevalent market sentiment". The second part is actually equally important. The same company will be valued differently in a bear and bull market even if their underlying business performance is not impacted. Case in point is say Infosys in 2000 and 2001. Same company, doing the same thing, but market value is a fraction of the past.

Every asset value can be broken up into two parts—i) intrinsic value, which is derived from its tentative future cash flows and ii) transaction value, which is derived from what value someone else will pay for it in a transaction. For example, a painting or a flower vase has no intrinsic value because there is no cashflow, but it has a transaction value based on what another person is willing to pay for it. This transaction value keeps changing from time to time based on many other factors like liquidity, political and social situation etc.

Now having said so many negative things about DCF, it leaves us with two practical questions. Firstly, does it mean that we should completely ignore that process and secondly, if not DCF, then what?

Let's try to answer them one by one.

The process of doing a valuation, especially one as rigorous as DCF, is very useful. It helps you walk through many aspects of the business and make your assumptions explicitly. Like what could be the revenue growth over time, what would be its components, at what margins etc. This helps in the understanding of the business in a much better manner.

And for the next question, I will let the great masters speak.

Munger: “Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.”

Buffett: “It’s true. If it doesn’t just scream out at you, it’s too close."

To summarize, you need to focus on understanding the business and its various levers well enough to figure out it is screaming at you to buy or sell. If you need excel for it, you don't know the business well enough.

This article first appeared in: https://www.cnbctv18.com/market/stocks/zomato-valuation-why-one-should-discount-dcf-method-of-valuing-stocks-10089761.htm

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