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