DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!

Mod Note (Andy) - as the year comes to an end we're reposting the top discussions from 2015, this one ranks #35 and was originally posted 2/24/2015.

Earlier this year, I started my series on discounted cash flow valuations (DCF) with a post that listed ten common myths in DCF and promised to do a post on each one over the course of the year. This is the first of that series and I will use it to challenge the widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash)F(lows). In this post, I will take a tour of what I would term twisted DCFs, where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.

The Consistency Tests for DCF

In my initial post on discounted cash flow valuation, I set up the single equation that underlies all of discounted cash flow valuation:

No Mas, No Mas! The Vale Chronicles (Continued)!

I have used Vale as an illustrative example in my applied corporate finance book, and as a global mining company, with Brazilian roots, it allows me to talk about how financial decisions (on where to invest, how much to borrow and how dividend payout) are affected by the ups and downs of the commodity business and the government’s presence as the governance table. In November 2014, I used it as one of two companies (Lukoil was the other one) that were trapped in a risk trifecta, with commodity, currency and country risk all spiraling out of control. In that post, I made a judgment that Vale looked significantly under valued and followed through on that judgment by buying its shares at $8.53/share. I revisited the company in April 2015, with the stock down to $6.15, revalued it, and concluded that while the value had dropped, it looked under valued at its prevailing price. The months since that post have not been good ones for the investment, either, and with the stock down to about $5.05, I think it is time to reassess the company again.

What's in a name? Of Umlauts, The Alphabet and World Peace!

As the title should forewarn you, this is a post that will meander from eating spots to basketball players to corporate name changes. So, if you get lost easily, you may want skip reading it. It is triggered by two events that occurred this summer. One is Google's widely publicized decision to rename itself Alphabet and to reorganize itself as a holding company. The other is the much less public news that the eating place across the street from the building where I teach will be reopening with a new name "Brod Kitchen", a new menu, and (probably) higher prices.

My Valuation Class: The Fall 2015 Model Preview

It is almost September and as the academic clock resets for a new year, I get ready to teach a new valuation class. With three hundred registered students, it is about as diverse a class as any I have every taught, with a mix of full-time and part-time MBA students, law and engineering graduate students and a few dozen undergraduates. And with a market meltdown framing discussions, it will be interesting to see how the class plays out. As always, I cannot wait for the class to start and as I have, each semester, for the last few years, I invite you to follow the class, if you are so inclined.

Setting the table

Valuation is an intimidating title for a class, stirring up visions (and nightmares) about spreadsheets, accounting statements and financial theory. This may be the default version of the class and it serves experts in the topic well to preserve this air of mystery and intimidation. I have neither the expertise nor the desire to teach such a class, and I hope that you will not only take my class, no matter what your background and experience, but that you will also learn to enjoy valuation as much as I do. The best way for me to start describing my class is to tell you what it is not about, rather than what it covers. So, here we go:

Beijing Blunders: Bull in a China Shop!

I have generally steered from using my blog as a vehicle for rants, not because I don't have my share of targets, but because I know that while ranting makes me feel better, it almost always creates more costs than benefits. It is true that I have had tantrums (mini-rants) about the practice of adding back stock-based compensation to EBITDA or expensing R&D to get to earnings, but the targets of those tend to be harmless. After all, what can sell-side Equity Research Analysts or accountants collectively do to retaliate? Refuse to send me their buy and sell recommendations? Threaten me with gang-audits?

This post is an exception, because the target of the rant is China, a much bigger and more powerful adversary than those in my mini-rants, and it is only fair that I let you know my priors before you read this post. First, I am hopelessly biased against the Chinese government. I believe that its reputation for efficiency and economic stewardship is inflated and that its thirst for power and money is soft-pedaled. Second, I know very little about the Chinese economy or its markets, how they operate and what makes them tick. It it true that some of my ignorance stems from the absence of trustworthy information about the economy but a great deal of it comes from not spending any time on the ground in China. So, if you disagree with this post, you have good reason to dismiss it as the rant born of ignorance and bias. If you agree with it, you should be wary for the same reasons.

The Chinese Economic Miracle: Real or Fake?

Storied Asset Sales: Valuing and Pricing "Trophy" Assets

Pearson PLC, the British publishing/education company, has been busy this summer, shedding itself of its ownership in two iconic media investments, the Financial Times and the Economist. On July 23, 2015, it sold its stake in the Financial Times for $1.3 billion to Nikkei, the Japanese media company, after flirting with Bloomberg, Reuters and Axel Springer. It followed up by selling its 50% stake in the Economist for $738 million, with 38% going to Exor, the investment vehicle for the Agnelli family, and the remaining 12% being purchased by the Economist Group itself.

The motive for the divestitures seems to be a desire on the part of Pearson to stay focused on the education business but what caught my eye was the description of both the Financial Times and the Economist as "trophy" assets, a characterization that almost invariably accompanies an inability on the part of analysts to explain the prices paid by the acquirer, with conventional business metrics (earnings, cash flows, revenues etc.).

Decoding Currency Risk: Pictures of Global Risk - Part IV

In my last three posts, I have looked at country risk, starting with measures of that risk and then moving on to valuing and pricing that risk. You may find it strange that I have not mentioned currency risk in any of these posts on country risk, but in this one, I hope to finish this series by looking first at how currency choices affect value and then at the dynamics of currency risk.

Currency Consistency

A fundamental tenet in valuation is that you have to match the currency in which you estimate your cash flows with the currency that you estimate the discount rate that you use to discount those cash flows. Stripped down to basics, the only reason that the currency in which you choose to do your analysis matters is that different currencies have different expected inflation rates embedded in them. Those differences in expected inflation affect both our estimates of expected cash flows and discount rates. When working with a high inflation currency, we should therefore expect to see higher discount rates and higher cash flows and with a lower inflation currency, both discount rates and cash flows will be lower. In fact, we could choose to remove inflation entirely out of the process by using real cash flows and a real discount rate.

Pricing Country Risk - Pictures of Global Risk - Part III

In my last two posts, I looked at country risk, starting with an examination of measures of country risk in this one and how to incorporate that risk into value in the following post. In this post, I want to look at an alternative way of dealing with country risk, especially in investing, which is to let the market price of country risk govern decisions.

Pricing Country Risk

If you are not a believer in discounted cash flow valuations, I understand, but you still have to consider differences in country risk in your investing strategies. If you use pricing multiples (PE, Price to Book, EV to EBITDA) to determine how much you will pay for companies, you could assume that the levels of these multiples in a country already incorporate country risk. Thus, you are assuming that the PE ratios (or any other multiple) will be lower in riskier countries than in safer ones.

Valuing Country Risk: Pictures of Global Risk - Part II

In my last post, I looked at the determinants of country risk and attempts to measure that risk, by risk measurement services, ratings agencies and by markets. In this post, I would first like to focus on how investors and business people can incorporate that risk into their decision-making. In the process, I will argue that while it is easy to show that risk varies across countries, significant questions remain on how best to deal with that risk when making investment and valuation judgments.

Groundhog day in Greece, Hijinks in Brazil and Market Chaos in China: Pictures of Global Risk - Part I

It’s been an eventful few weeks. Greece’s extended dance with default has left even seasoned players of the European game exhausted and hoping for a resolution one way or the other. In Latin America, Brazil’s political and business elite are in the spotlight as the mess at Petrobras spreads its poisonous vapors. On the other side of the world, the Chinese government, which finds markets useful only when they serve its purposes, is trying to stop a full fledged rout of its equity markets. For investors everywhere, the events across the world, discomfiting though they might be, are reminders of two realities. The first is that globalization, while bringing significant benefits, has created connections across markets that make any country's problem a global one. The second is that notwithstanding this globalization, some parts of the world are more prone to generate political and economic surprises than others. As companies and investors are forced to look outside their borders, I thought it would be a good time to examine how and why risk varies across countries and at updated measures of that risk.
The Sources of Country Risk


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