1. Whether I use a 10% or 8% required return, in practical terms I am still expecting growth to occur on the basis of previous qualitative research and basic fundamental screens, and when using an 8% required return I am just expressing slightly greater confidence that growth will occur and that I am willing to pay slightly more upfront for this. I am not trying to quantify the precise value or rate of that growth x years into the future by adopting a slightly lower required return.
2. RY, what is your view on the valuation approach used by Roger Montgomery and also Clime which don't use DCF and are based on a Buffett/Walters/Simmons approach?
3. Also, do you have an excel spreadsheet of your DCF model that you could attach for our interest and to play around with?
Hi TPI, hope all's good with you.
1. You can argue that, no problem. If the gap between growth and discount rate is largely preserved, there is no problem with moving discount rate and growth rate at the same time for small changes. For a fixed view on the world, this can roughly be thought of as changing the rate of underlying inflation embedded into the calculation. Decrease the inflation assumption, reduce the absolute level of the discount and growth rates. The gap is largely preserved and so is valuation (not quite, but somewhat close depending on a bunch of things).
To the extent that this happens without changing your underlying inflation assumptions, distortions of valuation relative to your actual expectations occurs. An example works best.
Imagine you have a company which is marginally able to meet its interest payments. These interest payments are fixed, but the cash flow from operations is not. If the rate of growth comfortably exceeds the growth rate of interest payments, credit risk declines as does the appropriate discount rate. The gap widens with improved growth. Conversely, if your growth rate declines, possibly to below the interest rate, this company is going bankrupt. Whilst there is a discount rate under the zero growth process that will result in a matching valuation derived by a more accurate depiction of what you think is actually going on, finding the best figure is totally unintuitive. If you allow for varying growth rates in the forecast, that concept becomes even less intuitive.
Forecast accuracy is poor enough, why add to it by further approximations? Valuations are trying to see what a company is worth. In order to do that, some realism would seem reasonable?
Though you seem to think changing the discount rate without trying to get a precise value for growth x years out omits the growth assumptions, you are really doing it anyway. You cannot assess the likelihood of earnings being achieved without having implicit or explicit views on their path.
Why use an unintuitive approach whose parameters do not match your best estimate/guesstimate of reality? The calculation is no more computationally difficult. However, it comes with the benefit of actually being able to see what you are assuming explicitly rather than through the veil of compromised assumptions that don't occur for the vast bulk of situations. You are already making assumptions...why not use better ones that you can actually see has a semblance of truth to them? Again, it is no more computationally intensive but comes with better intuition. Intuition in valuations is useful for stress testing. This is very important. Your reference to confidence in achievement of results is a form of stress testing. Why not do it explicitly?
2. Clime is using DCF. It is just doing it with a fixed growth rate after normalisation of the first year. Their growth rate is developed by RoE and payout considerations. Please note that they allow for growth (with a small mathematical twist involving what is known as a Taylor expansion) and have a market/judgement determined rate of return requirement. That's exactly in alignment with what I have been saying above. You are attempting to do this, but with assumptions that are approximate to the reality. Why not use something closer to reality! It is yet another example of industry practice diverging from the zero growth proposition. We can add a very large number of names to that. I can count on a finger those who purport to use a zero growth assumption.
Please note that a single growth rate after normalisation will lead to troublesome outcomes if the growth rate in different periods differ from the long term growth assumption. Clime are accepting material approximations in this approach, but a zero growth rate process is not one of them.
Take a look at how large the valuation associated with their example is relative to the zero growth (bond) component. This is how big the approximation of the zero growth proposition is being distorted....and this is typical. Zero growth assumptions are not really an effort at valuation for the purpose of investment. They are crash-and-burn calculations in some cases. But which ones? Because they are too optimistic for many. So it doesn't even serve the crash-and-burn purpose:
The idea is a close cousin to Ben Graham's approach, which also allows for growth and market/judgment discount rates.
It is a cut down version of Buffett's methods, but you'll see that his approach is not too much more sophisticated.
3. Sure.
Here is a link to the Stern School of Business, New York University.
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm They have a bunch of spreadsheets that illustrate and allow you to determine DCF calculations. I believe you should start with Focussed Valuation Spreadsheets, and the file "fcfe2st.xls". It illustrates the approach to value a company which has an initial growth rate assumption that differs from the terminal growth rate assumption. It is a two-stage model. The vast bulk of valuations are done with two or three stage models. Please note how light the assumption load is. It is only slightly more demanding that a single period valuation model. As a result, from normalised earnings and two growth rates, with a discount rate you get an intrinsic valuation. If you consider the computational load, it should be evident that it can be solved in the head of a seasoned practitioner within a few seconds.
There are many ways you can use this, but let's not start that here. In terms of the accuracy of the assumptions going in, it is very unlikely that you have absolutely no opinion whatsoever about the future path of growth. Any sight is better than no insight. You may not have confidence in their precision though. It is not precision which counts in investments. No-one has precision. What counts is margin of safety. You are trying to obtain this indirectly by varying the discount rate when you have increased confidence in earnings. Why not do this more explicitly? Again, the assumption load is basically identical for a single period valuation and slightly more challenging for a multi period one.
Further, I invite you to fire up "fcfest.xls" which is a single growth rate estimate. Please consider doing as follows:
1. Observe the overall discount rate and growth rate embedded into the spreadsheet as you open it.
2. Observe the valuation
3. Set the growth rate to zero.
4. Use your intuition to obtain a discount rate that matches the original valuation.
5. Check how much the 'hash' differs from the actual figure you are trying to approximate in the first place with more direct assumptions.
Finally, notice how the Stern School spreadsheets come pre-populated with growth assumptions that are not zero. Another one.
TPI, no-one uses a zero growth rate assumption as a blanket starting point in the professional market. I sincerely hope the reasons why are evident. In the end, I hope whatever method(s) you elect to use works out for you.
Cheers