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’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’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.
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