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Is this the best way to value stocks?

Mar 29, 2010

What does one do when one wants to learn something? One should obviously learn from the best in the field. We have decided to follow this principle to the tee. We want to learn about stock valuation. Thus, who better than the Oracle of Omaha, Warren Buffett in this field? After all, he has compounded money like few have in the field of investing. And since most of it has come from investing in stocks, he surely does know a thing or two about stock valuation better than most other investors.Fortunately for us, Buffett's wisdom does not lie locked in his brains. The man has been indeed very generous in sharing it with the rest of the investing community. Even we have had the chance to go through Warren Buffett's various writings and learn a great deal from them.

So, what has been our biggest learning when it comes to valuations?

If Buffett walks his talk, and we can confidently say that he does, he seems to rely extensively on discounted cash flow method for valuations. He has used a lot of analogies in his writings to give us the impression that the discounted cash flow method or the DCF method is something that comes close to being a perfect one for valuing stocks.

No great shakes you would say? DCF is being touted as a valuation method for ages now and there is nothing new that Buffett has said. This is where we believe lies the key difference. According to us, there is one fundamental flaw in the way the rest of the investing community uses the DCF and the way Buffett does. Infact, we believe that Buffett's method is what brings the DCF method out of theoretical textbooks and journals and makes it suited for the practical world. It gives it that edge which is badly needed.

Before we proceed, let us have a very short primer on DCF. As is widely known, DCF is the net cash inflows that accrue to the company over its entire lifetime divided by an appropriate interest rate. A standard DCF calculation has two parts, cash flow analysis for the first five year period and a terminal value calculation. The terminal value kicks in after the first five years. It is meant to imply that growth in cash flow does not add any value to the company as the cost of capital equals the return on capital generated by the company. And irrespective of the company under consideration, the DCF template more or less remains the same.

Any idea why only five years or some such period is considered before terminal value kicks in? We certainly have no idea. It is perhaps an arbitrary number. Or most people using the method believe that all companies experience a decline in return on capital and after five years, the same equals the cost of capital.

However, what if terminal value is not five years, but 10 years away. Infact, what if the terminal value does not come into the picture at all. The company is so strong competitively and has such a strong business model that it will forever earn greater than the cost of its capital. The company with a perpetual earning power greater than its cost of capital would of course be very difficult to come by. But there certainly are companies that earn greater than their cost of capital for many years into the future. These are the companies that Warren Buffett calls companies with very wide moats and loves to invest in. Obviously, using a two stage DCF with terminal value calculation after five years would tend to greatly undervalue such companies. And shrewd investors like Buffett take advantage of this approach that breaks down in the case of companies with strong moats. Furthermore, if such companies experience temporary disruption in business models, the terminal value is brought up even further. This is when investors who can separate the textbook DCF method from the real world DCF method can go for the kill. After all, the Oracle of Omaha has amassed most of his wealth exploiting this anomaly.

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