Tuesday, December 26, 2006

Discounted Cash Flow or DCF

Discounted Cash Flow or DCF is the most complicated way to value a stock and also probably quite useless to most people. Well, not if you are good at math or if you are called Buffett or Graham or Dodd. Buffett uses very simplified DCF to try to value stocks and is probably quite good at it, given how much he has earned (umm, in case you don't know, it's about 1/3 of what the whole of Singapore earns). Too bad he doesn't blog.

Well I guess I would just try to describe the concept of DCF, bcos the math will simply freak out a lot of people. But having said that, it's probably A level or 1st year university math so if you really want to know, can google it and try to figure it out.

Ok the concept is basically adding up all the cashflow over the life of the firm and try to determine how much it is today.

Perhaps it is easier to use an example:

Firm A will generate $1 of cashflow over the next 50 yrs, what is its value (or intrinsic value) today?

Well the simple answer is simply $1 x 50 = $50 (QED).

Ok, but how can be so simple?

Now we must understand that $1 next year is not the same as $1 today. And $1 two years out is also different. The difference is due to interest.

So $1 next year is actually equal to $0.97 today bcos if we put $0.97 in the bank today, it will earn 3% interest and become $1 next year. And $1 two years out is roughly $0.93 today bcos if we put $0.93 into the bank today, it will earn 3% interest in 1 yr, and both the interest and principal after Year 1 will earn another 3% interest, which brings the total to $1 two years from now.

So once we calculated the present value of all those future $1 (50 of them), we add them all up and we get the intrinsic value of the firm. For the above example, the answer is $25.7.

If you are wondering how to get $25.7, key this "=PV(3%,50,1,0)" in Excel and it will spit out the answer. Need more help, pls email me.

Well, not so hard after all I guess. But the questions below will make you realize what makes it hard.

First, how the hell do we know if Firm A can actually earn $1 every year for the next 50 yrs? And what will the interest rate be in 50 yrs time? And why only 50 yrs, shouldn't a company exist longer than that?

So that's the hard part, for every input, there is some uncertainty. With DCF, you can have infinite no. of inputs, and that's uncertainty times infinity. How fun. Personally I prefer to stick with PER and EPS estimates.

See also Intrinsic Value Part 2
and Definition: Value Investing

7 comments:

  1. hi J-chan,

    tried to look for an email to pose this question, eyes too small, can't squint enuff, here goes the question:

    Do you know where I can find the P/E ratio of Singapore and some of the countries around the region ? I have only found this link http://tickersense.typepad.com/ticker_sense/

    TIA

    raytoei
    http://boards.fool.com/Profile.asp?uid=158501944

    ReplyDelete
  2. Hi 8percent,

    I agree with your basic concept of present value of all future cash flows. In other words, the intrinsic value of the business. It is by the way meant to be as easy calculable as such, there is no such need to have any other complicated calculations that assumed or put unrealistic assumption into the maths.

    Then another thing for an investor to realise next is patience since in order for an intrinsic value to work out fine, one cannot just calculate its intrinsic value based on 10 years span of earnings flow. Because it will hardly give an intrinsic value which presents much discount or value to the stock price that you will likely have to pay for. Thus, as you say, long term, any thing more than 10 years is the time frame that one should have if intrinsic value is the basis for investing.

    Then many people will go "wow", "how can anyone ever predict a few years down the road, much less more than 10 years?" The answer lies in investing in business you can predict and understand with ease. Just like Warren, "Stay out of growth business or tech or any business that needs to constantly change its business products." There are some business which are very easy to predict and yet simple but surely not easy to be beaten in competition. For eg, retailers like Home Depot, Lowes, Walgreens, Wal-Mart, Costco, Tesco, Whole Foods Market, these business have predictable earnings given their business models and more importantly, they are pretty easy to predict for their future earnings given their plan by expanding stores in an organic manner, and of course, their past plans matched what they set out to achieve historically.

    Then you have business like Johnson & Johnson, Coke, Wrigleys, pepsi, Harley Davidson. These are business where its moot are pretty well instilled.

    So it is really not that hard to find businesses which will survive say many years down the road.

    The next question is when to buy? A great investor have the patience to wait for the right price while lying in wait.

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  3. Hi ray, regards your question about P/E ratio of STI, my latest estimate is 18.87 as of 17/12/2006. Though I must emphasize it's my personal calculation and might not be accurate.

    If you know of anywhere that provides accurate data, do let us know! ;)

    ReplyDelete
  4. Hi ray, when STI was 2400 or so it was around 15x, now it is close to 18x based on earnings in 07. 18.87 is probably based on earnings in 06. So depending on which year you want to look at, its a bit different but I whichever case it is, I think it's quite expensive, bcos 18x means you are can only 6% return on your investment after 1 yr. The market may realize that soon and the rally will be over.

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  5. Hi Berkshire, thanks for the comment. I hope that I will learn to appreciate discounted cash flow in time, probably then I can truly grasp the crux of value investing.

    My sense is that Buffett combines his calculation of intrinsic value and margin of safety. i.e. he make sure the market price is far below intrinsic value, that way even if he is wrong he gets the protection he needs which is very ingenious.

    If you have the time, can share an example of how you calculate intrinsic value of a real stock at your blog or mine, it will be insightful.

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  6. Hi 8percent, I have posted my thought process on deriving IV. Appreciate if you have any comments and your feedback if any. Thks

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  7. Los Angeles private equity firms borrow new money into existence in order to take these companies private. They inflate the money supply and syphon off huge sums as personal compensation. All the while, the cost of everything goes up as the value of a dollar goes down.

    ReplyDelete