James Montier on Inverting Discounted Cash Flows

James Montier is one of the more insightful investment analysts writing today. Montier is highly skeptical about discounted cash flows (DCF) because they rely on forecasting. He believes that the approach is theoretically correct – an asset is indeed worth the discounted present value of all future cash flows – but that it is fatally flawed in practice because, in his view, no one can make accurate forecasts.

In addition, he points out the problem of the terminal value: minor changes in the terminal growth rate and the discount rate dramatically alter the terminal multiple.

I think Montier raises good points but I think these limitations can be overcome if DCFs are used sparingly and with good judgment. One rational approach is to only use DCFs to value companies that have an established track record of stable earnings and a durable competitive advantage. The terminal multiple should be very modest. For example, you could only project earnings for five to eight years and then use a no-growth terminal multiple.

In general, if you use conservative estimates, you should be able to use DCFs to usefully value any asset if the gap between the present value and current price is large enough. Another approach, which was used by Benjamin Graham, was to show an example where it was only possible to establish a wide range of possible intrinsic values. No matter how wide the range, it was still useful if the current stock price was below that range.

Notwithstanding Montier’s distrust of forecasting, he does think that DCFs can be inverted to make transparent and explicit the growth assumptions that are baked into a stock’s current price. The investor can then use these new insights to assess if he is being overly optimistic and carrying too much risk.

Here’s Montier from the September 9, 2008 issue of Mind Matters:

So, if one can’t use DCF how should one think about valuation? Well, one solution that I have long favoured is the use of reverse engineered DCFs. Instead of trying to estimate the growth ten years into the future, this method takes the current share price and backs out what is currently implied. The resulting implied growth estimate can then be assessed either by an analyst or by comparing the estimate with an empirical distribution of the growth rates that have been achieved over time, such as the one shown below. This allows one to assess how likely or otherwise the implied growth rate actually is.

I thought it would be instructive to do this exercise with two widely held growth stocks: Apple (APPL) and Amazon (AMZN).

Apple

Apple’s current stock price is $287.75 (9/22/2010 close). I used consensus 2010 EPS of $14.48 (see Marketwatch) as the year 1 EPS. I assumed a discount rate of 12% or, said another way, I assumed that investors were looking for a 12% return from Apple’s stock. Assuming a no-growth terminal multiple, the current price assumes that Apple can grow at a rate of 15% per year for the next ten years.

Assuming a constant P/E ratio (and my other assumptions), this would mean Apple would need to have after tax earnings of over $50 billion in year eleven. To put that in perspective, the most profitable company in the Fortune 500 in 2009 was Exxon Mobil which earned $19.3 billion. Microsoft was second with profits of $14.6 billion. Wal-Mart Stores was third with profits of $14.3 billion. Thoughtful investors would want to look carefully at how Apple could grow its earnings to this level.

Amazon

Amazon’s current stock price is $151.83 (9/22/2010 close). I used consensus 2010 EPS of $2.64 (see Marketwatch) as the year 1 EPS. I assumed a discount rate of 15% or, said another way, I assumed that investors were looking for a 15% return from Amazon’s stock. Assuming a no-growth terminal multiple, the current price assumes that Apple can grow at a rate of 37.5% per year for the next ten years.

Assuming a constant P/E ratio, this would mean Amazon would need to have after tax earnings of over $28 billion in year eleven. Based on the consensus estimates, Amazon should earn about $1.2 billion in 2010. Here again, thoughtful investors want to look carefully at how Amazon could grow its earnings to this level.

Here’s the data.

Obviously, there are many ways that these assumptions could have been done. The point is that if an investor buys a given stock at a given price, he should make explicit the assumptions he is making given the current stock price, his expected return (the discount rate), the growth rate, the terminal multiple and the future P/E ratio.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures. The data and information presented in this blog entry is believed to be accurate but should not be relied upon by the user for any purpose. Any and all liability for the content or any omissions, including any inaccuracies, errors or misstatements in such data is expressly disclaimed.

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13 thoughts on “James Montier on Inverting Discounted Cash Flows

  1. Bob

    “Assuming a no-growth terminal multiple, the current price assumes that Apple can grow at a rate of 15% per year for the next ten years.”

    Great analysis! with respect to the above statement, can you advise how you came up with the figure of 15% per year for the next ten years?

    Reply
  2. Greg Speicher Post author

    Bob, what I did was an exercise in reverse engineering. I first assumed all the other variables: the current earnings, the discount rate, and the current stock price. I then simply put in the growth rate which is required to make the present value equal to the current stock price. I did it quickly by trial and error, i.e. plugging in values until they equaled. It could also be done algebraically.

    Reply
  3. Mo&Co.

    Greg you are doing a fantastic job of finding great, albeit difficult to find, Investment material. Please keep up the good work, this is fast becoming my favorite investment site, particularly love the article; ‘A Blueprint for Being a Lousy Investor’ pure genius IMO!!

    Reply
  4. red.

    7% discount rate, 75% ROIC & 5% growth rate will get you to current price with after-tax earnings of “only” $17bn. The real question re: AAPL is what ROIC — not growth — will look like over the next few years. it seems to me that this is indicative of a more general “wisdom”: P/Es — reengineered or not — reflect ROIC & the discount rate far more than they do expected growth.

    I enjoy your blog, btw.

    Reply
  5. nell

    earnings are an opinion – cash is a fact. using earnings in a dcf framework is simply wrong. especially, if there is such a big difference between net income and free cash flow in both cases.

    amazon

    FY09 – net income: $902MM, free cash flow: $2920MM

    apple

    FY09 – net income: $5704MM, free cash flow: $9015MM

    greg, one more try with these numbers? 😉

    best wishes,

    nell

    Reply
  6. Greg Speicher Post author

    Nell, great point. I agree that investors should focus on free cash. I did not intend the Apple and Amazon DCFs to be anything more than a simple example of how to invert a discounted cash flow. I wanted to keep it very simple to make the point that it forces an investor to closely look at all his assumptions. Perhaps I made it too simple.

    Reply
  7. nell

    garbage in, garbage out ..exchange your numbers and show us your new results 😉 ..maybe you need to adjust your conclusion as well.

    best wishes,

    nell

    Reply
  8. Greg Speicher Post author

    Nell, the post simply illustrates how to reverse engineer a DCF. I do not have an opinion on the future free cash flows for Apple and Amazon. I could study these companies a long time and I’m not sure I could. They operate in very competitive industries. I do think its fair to say that even plugging in free cash (instead of earnings), both require strong growth for a long-period of time to provide a satisfactory return at today’s price. Both may be able to do this.

    There are many ways these assumptions could have been made. Given the current stock prices, each holder of these stocks or interested investors who wants to do this type of analysis will need to plug in their own assumptions about free cash flows and see if they support their expected rate of return.

    By the way my year one EPS for AMZN was $2.64. With 447.8 million shares outstanding, that’s $1,182MM. I do note that a large part of AMZN’s 2009 free cash flow came from a large change in working capital. Do you view that as sustainable?

    Owner earnings were lower:

    Net income: $902
    Depreciation: 378
    CapEx: (373)
    FCF: $907

    In my spreadsheet, Apple’s year 1 EPS was based on consensus net income of $13.2 billion ($14.48EPS x 913.56M shares).

    Reply
  9. nell

    i dont criticize a reverse dcf or your approach at all. i just noted that eps numbers might not be very informative. furthermore i absolutely share your opinion that both companies operate in very competitive landscapes. therefore it is more speculation than investing to extrapolate any assumptions.

    “I do note that a large part of AMZN’s 2009 free cash flow came from a large change in working capital. Do you view that as sustainable?”

    -> yes, i think it is sustainable, because it’s a feature of their business model.

    ..here is what amazon says:

    “We generally have payment terms with our vendors that extend beyond the amount of time necessary to collect proceeds from our customers. As a result of holiday sales, at December 31 of each year, our cash, cash equivalents, and marketable securities balances typically reach their highest level (other than as a result of cash flows provided by or used in investing and financing activities). This operating cycle results in a corresponding increase in accounts payable at December 31. Our accounts payable balance generally declines during the first
    three months of the year, resulting in a corresponding decline in our cash, cash equivalents, and marketable securities balances.”

    (ref. page 10, 10-K)

    “Owner earnings were lower…”

    -> your definition of owner earnings is somewhat strange. i would say that an investment in working capital is essential for many companies. amazon is a special case because they can charge customers first and pay vendors later. so working capital is actually a capital source for them.

    ..here is mr. buffett definition:

    “If we think through these questions, we can gain some insights about what may be called “owner earnings.” These represent (a) reported earnings plus (b) depreciation, depletion, amortization, and certain other non-cash charges such as Company N’s items (1) and (4) less ( c) the average annual amount of capitalized expenditures for plant and equipment, etc. that the business requires to fully maintain its long-term competitive position and its unit volume. (If the business requires additional working capital to maintain its competitive position and unit volume, the increment also should be included in ( c) . However, businesses following the LIFO inventory method usually do not require additional working capital if unit volume does not change.)”

    (ref. berkshire hathaway – shareholder letter, 1986)

    -> working capital is a part of owner earnings. this makes sense, because as an investor i view a business simply as: cash in, cash out.

    best wishes,

    nell

    Reply
    1. mrt

      ““I do note that a large part of AMZN’s 2009 free cash flow came from a large change in working capital. Do you view that as sustainable?”

      -> yes, i think it is sustainable, because it’s a feature of their business model.”

      It’s sustainable and necessary as a constant, nothing more, so the effect on the firm’s present value is for all intents and purposes, over the long-term, fixed – it can be argued to be negligible.

      “working capital is a part of owner earnings. this makes sense, because as an investor i view a business simply as: cash in, cash out.”

      Working Capital = Current Assets – Current Liabilities

      Therefore, eg:

      If Long Term Liabilities Increased through a bond sale, Current Assets (Cash) would increase, hence there would be an increase in Working Capital. However there would not be a corresponding increase in Shareholder Equity (or as you would say, ‘Owner Earnings’), as the increase in Working Capital would be offset by the incease in Long Term Liabilities.

      Hence, as an investor, I can’t view a business as simply as ‘cash in, cash out.’

      Reply
  10. nell

    “It’s sustainable and necessary as a constant, nothing more, so the effect on the firm’s present value is for all intents and purposes, over the long-term, fixed – it can be argued to be negligible.”

    a constant?? sorry, could you explain?

    “If Long Term Liabilities Increased through a bond sale, Current Assets (Cash) would increase, hence there would be an increase in Working Capital. However there would not be a corresponding increase in Shareholder Equity (or as you would say, ‘Owner Earnings’), as the increase in Working Capital would be offset by the incease in Long Term Liabilities.”

    sorry, but we are talking about net operating working capital (inventories, accounts receivable, accrued expenses etc.). you are mixing financial items with operating items. cash flows from financing activities is not included in free cash flow (or owner earnings).

    Reply
  11. Deepa Puthur

    Hi Greg,
    The problem with this analysis is once you assume a zero terminal growth rate you frontload the required growth to justify your Current market price. If you assume a certain terminal growth you will automatically see a decline in the required growth in the intervening 10 yrs resulting in a substantially lower PAT number at the end of year 10.

    Reply
  12. Greg Speicher Post author

    Hi Deepa, thanks for the comment. Yes, assuming terminal growth will lower the required growth in the first ten years. The point of the reverse DCF is to see the level of growth you are assuming when you buy a stock. It makes sense to look at a range of growth scenarios. Many investors are highly skeptical of assuming a terminal growth rate because such a valuation is overly reliant on the growth coming after year 10. This type of forecast is risky and can lead an investor to pay a high multiple for a stock that is priced to perfection. If you are going to buy a stock like this that you assume can grow at 6% in perpetuity you should think long and hard about its moat and where the growth will come from.

    Reply

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