I remember seeing Secyh62 great commentary on modeling and why DCF is better.
Just want pros to clarify: when you are arguing for where something will trade in your target price. Doesn't that mean 1+ levers that drives future cash flow is changing? Like, in the future, either revenue is accelerating, operating margin is expanding, tax, capex or working capital is going down?
Am I right here? Or not quite?
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H.I.G.
Yes.
More on: revenue accel, margin expansion and capital intensity
less on taxes for me
Makes sense, we might have an election catalyst for tax incoming though! Thanks.
Short answer yes
More nuanced answer is that a multiple is driven by 3 things, changes in expectations for future ROIC, growth, and risk. You can see the relationship between these three drivers in the steady state value formula, which is Value = NOPAT x [1-(g/ROIC)] all divided by (WACC – g)
Growth is straight forward but I would point out the valuation sensitivity is generally strongest to organic growth (depends on view of how much value is created via growth from M&A, my default assumption is usually that M&A is value-neutral unless I have a lot of conviction around the management team’s competency). ROIC can be split into NOPAT margin and IC turnover. NOPAT margin is a function of your product/service level contribution margins (basically GM), operating leverage (fixed/variable mix in other opex), and tax assumptions (which absent tax reform are going to be relatively stable as it pertains to forward expectations). The two big drivers of IC turnover will be your working capital and your capex. Risk can be split into business risk and financial risk. Business risk is going to be your unlevered beta and financial risk is going to be your debt/equity mix.
So that is essentially how the factors your laid out roll up together and drive the multiple. Will add additional clarification that I rarely argue that a stock should trade at my price target, effectively implying that the market is wrong and that I am right. Rather, I project a range of outcomes and assess upside relative to downside risk to gauge opportunity. Said differently, I don’t believe I can see the future better than anyone else, which is effectively what you are saying if your argument is based on where you think something should trade. But we can use the DCF to reverse engineer what the market thinks (which requires a well-structured DCF to have any actual utility). From there we get to decide if we want to take the over or the under (think of it as the market is offering you a bet based on a set of forecasts for ROIC, growth, and risk; do you want to take it or not?), and if things turn out better or worse than what the market thinks today, how will that change the market’s perception of the future, and what will that mean for our upside and downside scenarios?
Whether a risk-reward being offered to us today by the market is attractive or not will depend on the quality of the business and how much uncertainty there is in our estimates. I.e. I don’t need 5x upside to downside on a stock like WMT where the range of outcomes is relatively bounded, but I might need something better than that on something like NVDA where the annualized vol is over 50% and the way things could unfold from here is pretty open-ended.
Thanks, GOAT!
Which one was the initial commentary by the GOAT you mentioned, about DCFs?
As someone who’s been on this forum for multiple years, it is rare to see a post of yours that hasn’t been voted as the most helpful. I feel like I can get an MBA-level education from just reviewing your post history and taking notes. This will be included in my textbook lol.
Absolute gem, thank you.
You mention structuring a reverse DCF well — could you please expand on that? I’ve had trouble understanding how I should think about projecting certain line items 30 yrs into the future and discounting it back to see what the market thinks today. For example, if I hold margins steady, I’ll get a different implied revenue growth than if I modeled in some margin expansion. Thanks!
Yes, it is about trying to figure out what ‘the market’ is modeling in so to speak. To do that you simply come up with different combinations for the key variables that get you mathematically to the current market price. Sell side consensus is a good starting point, but always remember that the market price reflects buyside consensus, not sell side (the sell side commits no capital to their ideas and they are often tethered to a band around whatever management has guided in order to maintain good standing with those management teams). The reverse DCF is how we try to figure out what buyside consensus is, and then from there we try to identify flaws in the consensus or points of conservatism/aggression that give us favorable risk-reward. High margin models will be most sensitive to changes in growth expectations and low margin models will be most sensitive to changes in margin expectations.
As always with any model, this is a garbage in garbage out exercise, so if you use a shitty model, you will get shitty results. I understand the apprehension WRT length of forecast but understand that this is what is priced into every stock that is expected to remain a going concern. Otherwise stocks would be priced like short duration bonds, with the value per share determined by the one or two years of cash flow that is most easily forecastable (assigning no value to the business beyond that) + maybe net liquidation value of the assets.
This is the type of insight that adds value to this forum. Kudos to you my friend.
Thanks, I just want to learn what I want to learn. I know if I am good, money will take care of me.
Looks like most posts here are about money without understanding skills needed to make them.
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