Michael Maboussin is in my opinion, one of the most influential writers on Finance. If you haven’t read the frontiers of finance series, you should. Yesterday. You may not agree with him but you will have read a very well thought out point of view which will prompt some serious critical thinking.
Now, let’s come to the latest from Mr. M. Morgan Stanley published an essay called Everything is a DCF Model. As always, Mr. M writes well, the PoV is cogent, and it generally makes sense and reads well.
I have never once used DCF in my life for actually coming up with the valuation for any of my investments. Exceptions being when I was trying to get a certain outcome (or a certain number for the Valuation) or to justify something brute force.
Here is the Formula:
It is for the most part, pretty self explanatory. What could possibly go wrong?
As it turns out, pretty much everything can. Both the numerator and denominator are in practice impossible to calculate with any degree of accuracy. You see, life doesn’t really work out the way excel projections do. Revenues don’t grow by 10% each year. Costs don’t decline each year or stay flat. Average revenue per user doesn’t grow like clockwork. Risk cannot be reduced to a number easily. Uncertainty is harder to capture even mentally on a good day, let alone in an infinite series expansion. And then there is the oxymoron called Terminal Value. Terminal Value allows me to make you a Trillionaire. Whether it’s in Zimbabwe dollars or US dollars is a different story altogether.
Young MBAs hoping to make it big in high finance try to reduce things to scenarios. In 2009 my scenarios used to be Base case, Stress case, Optimistic case. These days I guess the scenarios are Base case, Bull case1, Softbank / Alibaba / Tiger Global2?
Fundamentally, there isn’t much non-intuitive in the formula. The value of a company is the present value of all of its future cash flows. Calculate present value of all future cash flows, add it all up, and you get the value of the Company.
See the problem yet?
At a 10,000 feet level, of course the formula holds. It’s God’s inalienable truth sung by heavenly angels in perfect contraltos3. But come down to mortal plane of earth and things start breaking apart quickly. You see, coming up with the values of the 3 inputs for DCF is basically an act of faith. and I haven’t even begun to address the issues with calculating WACCs and how a startup can have zero cost of capital4. Beta is equally unreliable5. So what you have left is a pile of something. It just isn’t very useful in my opinion.
An analyst telling the GP/LPs to rely on DCF is either pulling a fast one or justifying a pre-agreed valuation number. If not, and if DCF is indeed the basis for a new investment, he basically saying this (quoting the Poet Laureate John Francis Bongiovi Jr.):
“Woah, we're half way there
Woah, livin' on a prayer
Take my hand, we'll make it I swear
Woah, livin' on a prayer”
So are we lost? Is civilisation as we know it doomed? Is the manna from heaven called DCF just a big con? Not really. The underlying ingredients still work. You just have to work a little harder. Here is a hypothesis:
In relative terms, businesses that generate higher cash flows while using lower capital at lower risk are more valuable.
The underlying assumptions of DCF effectively deal with Uncertainty, Risk and Cash Flows (and the capital needed to generate these cash flows), Lets dive in a little deeper:
Uncertainty: Of all my pet peeves, the one thing that I really find inexcusable is experienced people confusing risk with uncertainty. You can price risk. Uncertainty is the “someone got hit by a truck” call you will get on a Thursday afternoon as you decided to go home a little early. All bets are off when uncertainty strikes. However, some industries will have lesser levels of inherent uncertainty. Some industries will have mature structures and cyclicality (e.g. Cement, Auto). Competitive advantages and economic strengths (or weaknesses) will be sustained for reasons that can be easily understood. The drivers of success will be easily worked out and ruthless execution will allow for a disproportional growth. This isn’t to say that a (e.g.) Zomato is less valuable than a (e.g.) Birla Cement because of higher uncertainty. What I am however, saying is that over time, a Birla Cement’s trajectory is easier to work out than a Zomato’s. It doesn't mean you'll make less money in Zomato. It just means that you'll pop many more antacid pills on the Zomato track.
Risk: Unlike uncertainty (which is basically one not knowing what one doesn’t know), Risk is an easier animal to tame. In simpler terms, Risk is stuff you can see and price in today to make sure that the business you are buying will remain attractive 5 years from now. A coworker once said that all deals are good deals but at what price? Most businesses (at least in the Indian context) are terrible deals at any price. It should not be that huge red flags were missed or unmitigated contractually when the investment was priced. Risk and uncertainty are really two sides of the same coin. The same work - endless meetings, research, expert conversations will help navigate these. What will set a great PE investor apart from a poor one will be the knowledge of knowing what is risk, what is uncertainty, and how to address them.
Cash Flows and Capital Efficiency: Experience is a wonderful thing. It allows you to distill down noise into useful signals. As a young(er) investor, I used to fret on stuff like market size, revenue growth rate, margins, and so on. Not so much these days. The real stuff that matters is hard to capture in an Excel. In my admittedly limited and blinkered experience, the things that really matter are the intangibles - quality of management, how long have these guys worked together, brand strength, track record of executing well, moats and sustainable competitive advantages. What this manifests as is generally superior capital efficiency. More bang for the buck. Your RoE and RoCE are >30% - great. Here, take my money. RoE and RoCE indicate how much of the P&L translates itself into surplus cash. Cash is life sustaining oxygen.
Most people use Multiples because DCF is a pain to get right. P/E, EV/Revenue, or whatever else is the flavour of the month. It’s not an unreasonable or poor methodology. However, what the Multiple doesn’t capture is the quality of the cash flow and its defensibility. So when a banker is arguing why the latest company paying them 2% of your money as fees should be valued higher, take a step back. Look at the quality of the earnings and the cash flows. FY30E estimates of a Zomato’s P&L are much more likely to be absolute bullshit when FY30 actually rolls around. Just using the multiple is a recipe for crap returns. But if your thesis is predicated on moat, execution and team, and corroborated by the multiple derived valuation, by all means go for it.
I have also realized that when one is uncomfortable with the valuations, more often than not, we are subconsciously picking up on something that is too good to be true. Empirical observations tend to eat theory for breakfast. So, aim to be generally right, and build in a margin of safety. Even if you get your calls wrong, your capital wont go to zero. Governments may change regulations, disruption may rear its ugly head, assumptions underlying predictions may turn out to be absolute hogwash. Even then, as long as you were cognizant of the cash flows and quality of the cash flows when setting up the investment, it will likely not be disastrous.
Moral of the story: buy 8th or 9th decile businesses, but at less than 8th or 9th decile valuations.
So Maboussin is right. He quotes Warren Buffet, and I cant find a better way to conclude this than to quote the man himself:
“ . . . the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).
The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’ To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush— and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”
Everything is a DCF then. If not in letter, then in spirit.
Notice the emphasis on Bull. ‘nuff said.
Not knocking on any of them. Just appreciating and accepting that fundamentals of building durable businesses have changed. The thesis is still playing out.
Reference - Lucifer by Mike Carey, DC Comics.
This gem came from Mr. Damodaran. There is an IPO note somewhere on the internet where he calculated cost of capital as 0.00%. Go look for it. This, along with Chamath launching yet another SPAC to bail out his previous SPACs is the clearest sign of a bubble yet.
https://hbr.org/2002/10/whats-your-real-cost-of-capital