Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.

Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Is this the best way to value stocks? - Views on News from Equitymaster
  • E-MAIL
  • A  A  A
  • Mar 29, 2010

    Is this the best way to value stocks?

    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.



    Equitymaster requests your view! Post a comment on "Is this the best way to value stocks?". Click here!


    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

    Aug 18, 2017

    Buying the index now will hardly help make money in stocks even in ten years.

    Trump Takes a Beating (Vivek Kaul's Diary)

    Aug 18, 2017

    Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

    How To Read Your Mutual Fund Account Statement Correctly (Outside View)

    Aug 17, 2017

    PersonalFN simplifies the mutual fund account statement for you.

    This Small Cap Can Drive Chinese Players Out of India (and Make a Fortune in the Process) (The 5 Minute Wrapup)

    Aug 17, 2017

    A small-cap Indian company with high-return potential and blue-chip-like stability is set to supplant the Chinese players in this niche segment.

    More Views on News

    Most Popular

    Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

    Aug 7, 2017

    The data tells us quite a different story from the one the government is trying to project.

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

    Aug 8, 2017

    Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

    Aug 7, 2017

    Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms


    Aug 18, 2017 (Close)