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Morning Monkeys!

I'd like to take a moment to discuss the growing multitude of "finance hipsters" and why they annoy the crap out of me. No, I'm not talking about hipsters who happen to work in finance, I'm talking about all these bankers who love to hate on the more ubiquitous methodologies in finance like CAPM (or portfolio theory in general) and DCF models. You all know what I'm talking about, in fact, at some point, you (or someone you know) has probably had this conversation:

Banker #1:

Quote:
I'm going to get the cost of equity using CAPM and then get the intrinsic value from my DCF model.

Banker #2:

Quote:
Oh, you still use CAPM and DCF? Man, that's so déclassé, you know the assumptions they use, right? You should use [insert any obscure, probably firm specific model], it's way better.

Replace "the cost of equity using CAPM" and "the intrinsic value from my DCF model" with "Modest Mouse's new CD" or "non-organic milk" and you have the quintessential hipster conversation.

Are they perfect models? No, far from it, and "Banker #2" is right about the assumptions. But, both were huge leaps forward in analysis and deserve a bit more credit. To really appreciate this, it's important to understand what came before them:

Dow Theory: The predecessor to modern technical analysis was developed from 255 editorials written by Charles Dow. Imagine developing a financial theory from 255 of Paul Krugman's editorials, it would consist entirely of methods to purchase assets that reliably vote democrat and numerous footnotes on the awesomeness of inflation. Luckily, Charles Dow was a pretty smart guy so the resulting theory isn't complete and utter gibberish, but some of the 6 tenets of Dow Theory would strike most of you as pretty ridiculous (e.g. The Market has Three Movements.)

Theory of Investment Value: Finally, after figuring out that looking at candlestick charts leaves something to be desired, John Burr Williams thought, "Hey, maybe if we look at a company's cash flow or dividends, we'll be more readily able to determine a stock's intrinsic value." This is when Fundamental Analysis was truly born and with it, the dividend discount model and the DCF model.

Portfolio Theory: While actually checking to see if a company made any money, then buying said stock was a massive improvement, the concept of "diversifying risk" was still absent. This is where portfolio theory truly formalized the concept of a "diversified portfolio". Not to suggest that previously everyone had only one stock in their portfolio, or that the general concept was foreign to a professional analyst, but there wasn't a generally accepted formulation for HOW to diversify. This is how Markowitz's portfolio theory brought us into the modern world of stock analysis, by taking the next jump to include a formalization of risk and portfolio diversification.

So, the lesson here is, while models have improved dramatically in terms of their ability to model reality with more reasonable assumptions, they're still (more or less) innovations on portfolio theory and fundamental analysis (one could argue that the Black-Scholes option pricing model was an equally impressive leap, but I'd rather not muddle up my own argument.) This is precisely why every finance undergrad is forced to learn all of these seemingly outdated models.

Stop hating.

tl;dr - DCF models, fundamental analysis, and portfolio theory are awesome and a similar leap forward in how we analyze assets has yet to come about. Stop hating.

1

Comments (28)

  • FeelingMean's picture

    I lol'd...

    "That dude is so haole, he don't even have any breath left."

  • Onetwobit's picture

    Yes. They are awesome I concur :)

  • SirTradesaLot's picture

    I don't get it...you think it's annoying that people have come up with better ways of doing things and are touting their ways?

    adapt or die wrote:
    What would P.T. Barnum say about you?

    MY BLOG

  • In reply to SirTradesaLot
    mikesswimn's picture

    SirTradesaLot wrote:
    I don't get it...you think it's annoying that people have come up with better ways of doing things and are touting their ways?

    No, not at all. In fact I'm a huge fan of people coming up with new things and subsequently touting their new and improved methods. What's annoying is when people come up with absolutely nothing but still complain about the assumptions and methods of others. For example:

    "I've found that [insert assumption] doesn't represent reality in an empirically meaningful way, so I've developed [insert new method] that solves the problem" = Awesome and constructive.

    "The assumptions that are used in [insert model/methodology] don't represent reality, so obviously everyone who uses [previously inserted model/methodology] is an idiot because they so obviously don't realize how useless and limited [previously inserted model/methodology] is" = Annoying and makes me hope the author gets ambushed by a pack of squirrels.

    "My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."

  • In reply to mikesswimn
    SirTradesaLot's picture

    mikesswimn wrote:
    SirTradesaLot wrote:
    I don't get it...you think it's annoying that people have come up with better ways of doing things and are touting their ways?

    No, not at all. In fact I'm a huge fan of people coming up with new things and subsequently touting their new and improved methods. What's annoying is when people come up with absolutely nothing but still complain about the assumptions and methods of others. For example:

    "I've found that [insert assumption] doesn't represent reality in an empirically meaningful way, so I've developed [insert new method] that solves the problem" = Awesome and constructive.

    "The assumptions that are used in [insert model/methodology] don't represent reality, so obviously everyone who uses [previously inserted model/methodology] is an idiot because they so obviously don't realize how useless and limited [previously inserted model/methodology] is" = Annoying and makes me hope the author gets ambushed by a pack of squirrels.


    Got it, thanks.

    adapt or die wrote:
    What would P.T. Barnum say about you?

    MY BLOG

  • suchislife's picture

    My take is that the models were a stepping stone to multifactor models ( which have been proven to work so long as there are no pattern breaks i.e. 2008 crash) and that is why they are studied, its like studying Plato or Socrates its part of the classic foundation of Finance Theory.

    Then the industry (i.e. bankers) just because it needs a common method to communicate to clients adopted the CAPM model, it does not mean its the best one, think blue-ray vs. HD DVD, its just the one that everyone uses, hence it is more practical.

    For the sake of accuracy a well greased multifactor model should effectively get a better cost of capital(if its properly built), nonetheless most of those models are proprietary and hence any one not familiar with the model would have a steep learning curve in order to understand how the discount rate was arrived at WHICH IS KEY WHEN COMMUNICATING THE VALUE OF A COMPANY.

    So in summary:

    For Bankers or Valuators: Using CAPM is part of the industry language, so I would not frown upon it, as valuations can be tweaked by other drivers like growth, margin %, etc. to arrive at the right number for the company.

    For Investors: If you use CAPM you are seriously delirious as we all know its not accurate, and if you base of an investment decision on a piece of knowledge that you beforehand know is inaccurate, guess what?! YOU ARE AN IRRESPONSIBLE INVESTOR!!

    just my $0.02

  • Oscar_chow's picture

    OMG is CAPM important? I totally just ignored it in my Financial Economics assignment. I thought half of this stuff was crap. Aghhhh

  • Ovechkin08's picture

    Out of curiosity...how long does it generally take for new finance concepts from Universities to find there way onto the floors of an IB?

  • In reply to suchislife
    Oscar_chow's picture

    @Suchislife

    This is really interesting. I'm studying asset pricing right now, and I agree with how you think CAPM was a stepping stone to the multi factor model. Could you shed some light on your view of the arbitrage pricing theory and it's relevance in the real world? (If you have knowledge of it) From what I have learnt the imposition of arbitrage framework on the multi-factor model underpins it's modern use. By eliminating the systematic and systematic risk, the inclusion of variables outside the realm of measure like macro-events provides a linear relationship between these factors and the rate of return on an asset. I'm interested in how applicable this is in the real world. Does it help reveal patterns between asset pricing?

  • In reply to Ovechkin08
    mikesswimn's picture

    Ovechkin08 wrote:
    Out of curiosity...how long does it generally take for new finance concepts from Universities to find there way onto the floors of an IB?

    That's a really good question (hopefully someone has a better answer than the one I'm about to give.) The research I read tends to be pretty math heavy, which I'm assuming is typical (this could be totally wrong.) So for a quant shop with plenty of mathematicians and programmers, I'd imagine it would be pretty quick, if not in reverse (i.e. the research starts at the quant shop then is formalized by academia.) But if you were involved in deals which require a lot more flexibility from day to day (a trading machine can be run for quite a while, but a pitchbook is probably only good for the one client) it probably takes years, if not longer.

    Just a guess, though.

    "My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."

  • Going Concern's picture

    Bros you've got this all mixed up. A model like CAPM is vintage given its from the 60s, and not only that but it's also ironic because its usefulness is so limited and yet so much money is on the line. Then again all the banker bros worship it so it's also in the finance mainstream. What's a finance hipster to do when something is simultaneously vintage, ironic, mainstream and passé? You couldn't have liked CAPM before it was cool because you weren't even born yet! So that's off the table. Man, let me tell you, it is not easy being a finance hipster.

    “A deception that elevates us is dearer than a host of low truths”

  • BTbanker's picture

    I just use the classic "whichever stock price is higher is more expensive" theory. Am I missing something here?

  • suchislife's picture

    @ Oscar_Chow

    Well I'm pretty rusty on the subject but I'll give it a shot (last time I studied finance theory was in 2011 when I was wrapping up the CFA, have been working in PE where all of this is mostly irrelevant to my day).

    Well my take is that first of all there is no defined model for APT and hence the factors and betas are to be defined by the actual statistical analysis of the user. Assuming you have a model built on APT, which mostly looks at system wide macro factors, as long as the factors you incorporate in the model in the case of APT are statistically relevant factors which improve the correlation this should positively impact the accuracy of your model, and the more accurate your model is the better it will be on achieving the right cost of equity, and hence it will be better for making investment decisions. (This model definitely appears more relevant to the real world than CAPM, you could argue that CAPM is a subset of APT)

    On the other hand there are other fundamental statistically relevant factors which are not necessarily macro which affect company values, examples of such factors are stock liquidity, firm size, reporting quality, etc. As you built your model thought the statistical analysis of certain factors you will want to incorporate the number of statistical factors which positively improve your correlations, whether they are macro, or fundamental.

    If I’m not mistaken this is what happens in the real world, you build your model across a whole host of factors and betas (could be 2 could be 100 betas) trough statistical analysis in order to improve correlations and the accuracy of your model (always looking out for statistical traps, that’s another conversation).

    It is important to note that any pricing model developed through statistical analysis will be valid only until the patterns holds, if there is a structural break (example: oil stops being used and nuclear power becomes the power of choice, your statistical model will not likely hold) your model will break down and it will become useless (for a period of time at least) hence models are always constantly evolving 24/7 as the world and the economy evolves and that is why there will never be one model for anything as it is a constantly evolving analysis which incorporates all of the applicable factors for today!

    DISCLAIMER: SOMEONE IN ASSET MANAGEMENT PLEASE CHIME IN, TO MAKE SURE I’M NOT MISTAKEN, AS I AM VERY RUSTY AND I WANT TO MAKE SURE I DON’T GIVE BAD ADVICE! (I APOLOGIZE AHEAD FOR ANY MISTAKES, IT’S BEEN A WHILE) What a rant....

  • In reply to Going Concern
    mikesswimn's picture

    Going Concern wrote:
    Bros you've got this all mixed up. A model like CAPM is vintage given its from the 60s, and not only that but it's also ironic because its usefulness is so limited and yet so much money is on the line. Then again all the banker bros worship it so it's also in the finance mainstream. What's a finance hipster to do when something is simultaneously vintage, ironic, mainstream and passé? You couldn't have liked CAPM before it was cool because you weren't even born yet! So that's off the table. Man, let me tell you, it is not easy being a finance hipster.

    Lol! Epic.

    "My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."

  • In reply to suchislife
    Oscar_chow's picture

    suchislife wrote:
    @ Oscar_Chow

    Well I'm pretty rusty on the subject but I'll give it a shot (last time I studied finance theory was in 2011 when I was wrapping up the CFA, have been working in PE where all of this is mostly irrelevant to my day).

    Well my take is that first of all there is no defined model for APT and hence the factors and betas are to be defined by the actual statistical analysis of the user. Assuming you have a model built on APT, which mostly looks at system wide macro factors, as long as the factors you incorporate in the model in the case of APT are statistically relevant factors which improve the correlation this should positively impact the accuracy of your model, and the more accurate your model is the better it will be on achieving the right cost of equity, and hence it will be better for making investment decisions. (This model definitely appears more relevant to the real world than CAPM, you could argue that CAPM is a subset of APT)

    On the other hand there are other fundamental statistically relevant factors which are not necessarily macro which affect company values, examples of such factors are stock liquidity, firm size, reporting quality, etc. As you built your model thought the statistical analysis of certain factors you will want to incorporate the number of statistical factors which positively improve your correlations, whether they are macro, or fundamental.

    If I’m not mistaken this is what happens in the real world, you build your model across a whole host of factors and betas (could be 2 could be 100 betas) trough statistical analysis in order to improve correlations and the accuracy of your model (always looking out for statistical traps, that’s another conversation).

    It is important to note that any pricing model developed through statistical analysis will be valid only until the patterns holds, if there is a structural break (example: oil stops being used and nuclear power becomes the power of choice, your statistical model will not likely hold) your model will break down and it will become useless (for a period of time at least) hence models are always constantly evolving 24/7 as the world and the economy evolves and that is why there will never be one model for anything as it is a constantly evolving analysis which incorporates all of the applicable factors for today!

    DISCLAIMER: SOMEONE IN ASSET MANAGEMENT PLEASE CHIME IN, TO MAKE SURE I’M NOT MISTAKEN, AS I AM VERY RUSTY AND I WANT TO MAKE SURE I DON’T GIVE BAD ADVICE! (I APOLOGIZE AHEAD FOR ANY MISTAKES, IT’S BEEN A WHILE) What a rant....

    Thanks a lot for the reply, refreshing to hear real life applications instead of theory!

  • BTbanker's picture

    How did the hipster drown?

    It went ice skating before it was cool.

  • In reply to BTbanker
    mikesswimn's picture

    BTbanker wrote:
    How did the hipster drown?

    It went ice skating before it was cool.

    Ha!!

    How many hipsters does it take to screw in a lightbulb?

    It's a really obscure number, you probably don't know about it yet.

    "My caddie's chauffeur informs me that a bank is a place where people put money that isn't properly invested."

  • CaR's picture

    personal favorite: How much does a hipster weigh?

    An instagram

  • Going Concern's picture

    Why are farmers better than Hipsters?
    Farmers can go a day without their Pitchfork.

    What happens when a Hipster falls?
    They Tumblr.

    “A deception that elevates us is dearer than a host of low truths”

  • In reply to Ovechkin08
    labanker's picture

    Ovechkin08 wrote:
    Out of curiosity...how long does it generally take for new finance concepts from Universities to find there way onto the floors of an IB?

    Never. I remember I learned this ultra theoretical LBO analysis method senior year of college (supposedly was on the bleeding edge of academic corporate finance). After having been in IB and PE for a few years, I can safely say that no one on the planet (outside of academia) uses that analysis or anything other than a straight sources and uses / IRR / multiple of capital model to analyze the financial impact of an LBO.

    Yes, banks do use DCFs to fill pitch books and satisfy accountants and lawyers for reporting purposes, but no one is actually going to write a check based on a DCF.

    The reason none of the theory coming out of academia makes it to the real world is because unlike actual hard sciences, corporate finance and economics hypotheses cannot really be tested so most "theories" are just BS speculation.

    And if you are ever left wondering what your cost of equity should be, here it is: the percentage by which you want to grow your money.

  • In reply to labanker
    suchislife's picture

    labanker wrote:
    Ovechkin08 wrote:
    Out of curiosity...how long does it generally take for new finance concepts from Universities to find there way onto the floors of an IB?

    And if you are ever left wondering what your cost of equity should be, here it is: the percentage by which you want to grow your money.

    AMEN!

  • vitaminc's picture

    Who the hell still uses CAPM or DCF to value a company? Professional knife catchers that had AAPL at $1000 PT and bought from $700 to $525? Or professional value investors that bought HP from $25 all the way to $13?

    Even value shops' water cooler talks are spoken in P/E or P/S.

    Your model and valuation is only as accurate as your forward prediction of the company.

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  • snakeplissken's picture

    Remember, once you're inside you're on your own.
    Oh, you mean I can't count on you?
    No.
    Good!