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Why we are not a big fan of DCF valuation technique...

Apr 29, 2014

In this issue:
» Rich poor divide worst in China, surpasses US
» Bank of America's math goof up: Stress tests output incorrect
» Can gold touch US$5,000?
» The impact of El Nino on agricultural GDP growth
» ...and more!

Valuing a company is the most critical aspect of investing. After all, valuations help us decide if the company is worth buying or not. As such, the decision to choose an appropriate valuation model has always been a matter of debate amongst analysts. And the general belief is that more granular the model is, more defined the output will be. In other words, if the valuation model factors in the effect of every possible variable, it is more complete in nature.

Discounted Cash Flow (DCF) models serve this purpose pretty well. They are quite detailed in nature and require multiple inputs. For instance, in order to estimate the intrinsic value of a stock via DCF, numerous assumptions have to be made about cash flow, cost of capital, beta, risk free rate etc.

While many believe that such models give us a defined output, we feel they do more harm than good. The reason is simple. If the valuation model is more detailed, it is more susceptible to forecasting errors. More the number of variables, more the number of assumptions you need to make. This increases your margin of error.

Further, such models create a false sense of confidence amongst analysts. They believe that their forecasts will be more accurate as they have incorporated every bit of information. However, they forget that during this process they have become susceptible to forecasting errors.

Let us explain this with a help of simple example. Take the case valuing L&T through DCF. Being a conglomerate it has presence in engineering, hydrocarbons, IT and financial services businesses. Further, it also has strong international reach. Thus, apart from domestic business diversity, global taxation structure and currency factors also affect the company operations.

So, an investor who tries to incorporate the impact of all these variables in his valuation model will be more susceptible to forecasting errors given the magnitude of assumptions he would need to make. Not to mention that certain factors like perpetual growth rate which are highly subjective, greatly influence the intrinsic value. In short, DCF model will fail to serve the purpose here.

In fact, complex models like these fail to serve the purpose quite often. They bombard one with excess information. Also, the output of such models is quite sensitive to changes in assumptions. Again such models fail to accurately value cyclical companies or corporations that do not generate consistently healthy cash flows.

One also becomes susceptible to information overload and loses the big picture view, the result being a poor investment decision.

So, rather than focusing too much on the output of such models, investors should rather devote time in understanding the business. Time devoted towards that can be more fruitful. It can enable investors to arrive at a better investment decision rather than being subject to vagaries of forecasting errors.

Do you make use of complex models while making your investment decisions? If yes, do you think they are worth the time and effort? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
Unfortunately this year we cannot dismiss monsoons as a case of oversight. That's because the Indian Meteorological Department has raised the likelihood of deficient monsoons. The possibility of an El Nino phenomenon that disrupts the seasonal monsoon cannot be ruled out. And the resulting draught-like scenario would dampen the agricultural output of India. Consequently, the rural demand would bear the big brunt. It is too early to press the panic button yet. For the historical data has shown mixed results. Have a look at the chart below. The Livemint daily tells us that in the draught year 2002, the agricultural output took a hit. Whereas in the draught year 2009, the output remained flat! While the history might be less convincing, we need to note that many companies have expanded their reach into rural areas to support sales growth. And therefore scanty monsoons could now be a risk-factor for corporate India. As such, this should ring a warning bell for the investors who intend to accumulate consumer stocks. For now, they should take cognizance of the weather as a risk-factor before taking investment decisions.

How has El Nino impacted agricultural GDP?

There's a new book that's creating quite a ripple in the world of economics of late. At its core is the argument that a capitalist society and income inequality go hand in hand. And it illustrates how this is indeed true in the US where the top 10% earn around 40% of the country's income. So far so good. But here comes another piece of news that will burn a mighty hole right through this argument we reckon. Apparently, an agency has just completed a study on income inequality. And it has argued that the income gap between rich and poor in China has surpassed even that of the US and is amongst the widest in the world. See the dichotomy here. If it is a capitalist society that creates the widest income inequality, how come a communist nation like China faces this notoriety?

Well, we have a better theory we believe. Income inequality has more to do with Government intervention and lack of free market policies than anything else. Therefore, the key is to leave the economy alone and not meddle too much into it. Unfortunately, exactly the opposite seems to be happening right now. Thus, it will not surprise us that things get worse before they get better on this front.

To bet on gold or not! Well... the debates go on. While gold bears believe the metal with the safe haven status is no more attractive due to the bounce back of the US economy, the bulls believe otherwise. The CEO of Euro Pacific Capital Peter Schiff is part of the latter team. In fact, he has been bullish on gold for a while now. And with gold prices having moved up by 8% since the start of the year, he believes the party for the yellow metal has just started.

With a broad view that the Fed will have to admit that its forecast for the sustained recovery is wrong, thereby leading to a reversing of tapering actions, Mr. Schiff expects gold to touch as high as US$ 5,000 per ounce. Gold is currently hovering around the US$ 1,300 mark. His other arguments for gold include the full pricing in of the US tapering, weak dollar, rising commodity prices, possible geopolitical concerns and renewed physical demand from emerging markets. Given the uncertain times ahead, especially considering the possible struggle of the US government to keep its economy on the road to recovery - especially after years of money printing - it would be advisable for investors to have a certain amount of allocation (5% recommended) to gold as part of their overall portfolio.

The too big to fail banks in the US have been under constant pressure to prove their financial well being. The Federal Reserve has therefore been conducting what it calls 'stress tests'. These tests are meant to assess the banks' capital strength relative to size and quality of assets in their books. Now Citibank has not fared well in these tests in 2 out of last 3 years. However, it turns out that the second largest US bank by assets, Bank of America (BoA) is hardly better off! In fact as per CNN Money BoA has got the math about its capital adequacy calculation entirely wrong.

The bank has explained that the error was caused by an incorrect adjustment related to bad debts. The error occurred when the bank acquired Merrill Lynch in 2009. Given the concerns over BoA's capital, the Fed ordered the bank to suspend its buy back plans. In addition, its dividends will also have to be curtailed. Thus, while the TBTF banks themselves need to put their house in order; the Fed's inability to assess the risks via stress test needs to be highlighted.

Mounting stressed assets have been the biggest menace for Indian banks as well as corporates in the past couple of years. Not to mention slower economic growth, stalled projects due to lack of funds and rise in interest rates which have proved to be a bane on the balance sheets of these lenders. RBI has emerged as the knight in shining armour for such banks and companies by setting up a new framework on restructuring of non-performing assets (NPAs) and their sale to asset reconstruction companies (ARCs).

ARCs are RBI-licensed entities specialised in loan recovery which buy bad loans from lenders at a discount and then recover these loans from the borrowers. As per the new norms, banks can not only sell sub-standard assets but can also reverse the excess provision on the sale of such assets in case of a sale value being higher than the net book value of the assets.

Post the new framework there has been an unprecedented rush to sell stressed assets. As per an article on, banks and companies have sold stressed assets worth Rs 220 bn for FY14. This indeed is record breaking as compared to sale of just Rs 9 bn worth of assets in FY13. Thus, RBI's new framework is praise worthy as there was a need for faster and more systemic approach to recover bad loans. However, a hassle free sale of assets is not the only remedy for the bad loan peril. The lenders in the first place should strengthen their credit appraisal system and due diligence procedures. Having said that, the government should also work towards improving the overall health of the economy to tackle origin of bad loans.

In the meanwhile, the Indian stock markets continued to slip below the dotted line. At the time of writing, the benchmark BSE-Sensex was down by 172 points (-0.8%). Barring realty and consumer durable, all the sectoral indices were trading in the red. Metal and banking stocks were the biggest losers. Majority of the Asian stock markets were trading positive with Hong Kong and China being the major gainers. However, the Japanese index is trading down. European markets opened the day on a positive note.

 Today's investing mantra
"The more you trade, the more you underperform" - Warren Buffett

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6 Responses to "Why we are not a big fan of DCF valuation technique..."


Apr 30, 2014

DCF, IRR, Pay Back period and other such quantitative techniques are very useful for the promoters to decide whether to go for a particular project or not. It is also useful for the banks and other financiers who give long term (for more than a decade or two) loans for the project.

For a minority investor who would like to sell away his shares within a decade, there are other more important considerations of short term interest. If a project shows very good IRR or DCF values after a gestation period o five years, it is too long a time for the minority investor.



Apr 29, 2014

DCF for people who are running the business at CXO levels and understand the business Nitty gritty (variables). Not for Outside in view points and their blah blahs (expert fin analysts)....


Saradindu Datta

Apr 29, 2014

I absolutely agree with this point and never used complex statistical/financial model for investment. Even
if I make the efficient market assumption ( although that is not true for Indian Market OR any human-driven system) we can not forecast accurately about the future outcome. Hence understanding of the business is important ( and that make the difference among us, somebody will be a great investor and somebody not)to make the investment here. Apart from that, risk mitigation strategy OR portfolio diversification will be also important. Understanding of all these things comes from the experience, and would suggest do not play 'Fatka" in the market, instead of take advice from expert ( not too many)and try to understand that and then invest.


Rajeev K Arora

Apr 29, 2014

Agree with your approach.

One suggestion - a specific sector / industry may have a significant factor impacting it in the near term. Though you are the experts on valuation of a company from a financial, management, etc. aspects, an industry expert's advise may help you refine your valuation.

I have 34 year's experience in the IT industry, including senior management positions. I recently commented on your recommendations on Infosys stock in the club. The IT services industry is going to be seriously impacted in 3 to 5 years due to exponential technology change. I am not claiming to be an expert but such analysis may help you refine your valuations.

Like (1)

Pabitra Saha

Apr 29, 2014

DCF is only one of the several models.
Not using any is a perfect exercise in futility, like shooting arrow in dark.
A model is definitely better than no model.
many of the models do not require that much data and time and have built in correction techniques, which minimise subjective inputs.

Like (1)


Apr 29, 2014

I think the author of the article is either not knowledgeable enough or does not understand valuation subject at all. There are perils of any method one uses for valuation and each one has positives and negatives. Author is not suggesting any other method or model for valuation, simply saying that focus on management, that is true for any method one uses. Complexity of the situation with an example of L&T in fact underscores the point that one has to spend lot more time in understanding business dynamics of each of the business unit / geography, industry and of course the management. Real issue is that most analyst have used DCF simply as excel spreadsheet approach without going through rigours of the exercise.

There are no perfect models, it is what you like it and what makes you better in decision making.

Can author suggest alternative?

Like (1)
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