If Not DCFs, Then What is Used?

Hi,

I apologize if this is a stupid/noob question, but one thing that I found interesting is that a lot of hedge fund and even Equity Research Analysts that I spoke with (which admittedly isn't a ton) said that they barely use DCFs when figuring out if something is undervalued. One analyst even went as far to say that DCFs are "a great exercise in mental masturbation and that (he doesn't) weight them at all".

This seems completely different from what I would have thought and I was wondering then how value investors go about finding undervalued stocks typically. I know multiples are used frequently, but other than that, do they use more qualitative observation or what methods are used to uncover mispriced companies (btw, I'm speaking purely from a value investor/fundamental analysis standpoint)?

Thanks!

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Comments (43)

Feb 28, 2013 - 10:24am

Accrual Dictator:
Hi,

I apologize if this is a stupid/noob question, but one thing that I found interesting is that a lot of hedge fund and even equity research analysts that I spoke with (which admittedly isn't a ton) said that they barely use DCFs when figuring out if something is undervalued. One analyst even went as far to say that DCFs are "a great exercise in mental masturbation and that (he doesn't) weight them at all".

This seems completely different from what I would have thought and I was wondering then how value investors go about finding undervalued stocks typically. I know multiples are used frequently, but other than that, do they use more qualitative observation or what methods are used to uncover mispriced companies (btw, I'm speaking purely from a value investor/fundamental analysis standpoint)?

Thanks!

DCF's don't mean a whole lot in the public markets - you already have observable, realizable values at your fingertips. You pretty much hit the nail on the head with multiples, but I think fundamental analysis is just as reliant on qualitative measures as it is quantitative metrics. Two similar companies might be trading at very different multiples - the key is to understand why those multiples are different and whether or not the disparity is rational or not based on the company's prospects.

I think DCF's are probably more useful/common for value investors that have a longer time horizon, but I could be off the mark.

Disclaimer: Not in a buyside role.

"For I am a sinner in the hands of an angry God. Bloody Mary full of vodka, blessed are you among cocktails. Pray for me now and at the hour of my death, which I hope is soon. Amen."
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Feb 28, 2013 - 11:35am

duffmt6:

DCF's don't mean a whole lot in the public markets - you already have observable, realizable values at your fingertips. You pretty much hit the nail on the head with multiples, but I think fundamental analysis is just as reliant on qualitative measures as it is quantitative metrics. Two similar companies might be trading at very different multiples - the key is to understand why those multiples are different and whether or not the disparity is rational or not based on the company's prospects.

I think DCF's are probably more useful/common for value investors that have a longer time horizon, but I could be off the mark.

Disclaimer: Not in a buyside role.

This is pretty much it. 20-30 years ago, before everything was available online, you could find undervalued companies just by plowing through hundreds of 10k/q's and running DCFs. ValueLine was actually able to generate alpha. This isn't the case now.

Even in the best case, forecasts are horribly inaccurate more than 1-2 years out. And then companies can have very different equity risk premiums - and CAPM is a terrible tool to estimate it. Beta itself is nonsense.

Multiples matter, but multiples are driven largely by assumptions/qualitative factors. Will company A grow faster than company B? Why do they trade at the same multiple? Does company A have greater business uncertainty?

Or you can adopt a different perspective than the market. The market discounts Intel's new low-power chips, but maybe you think they will be wildly successful in the mobile market.

Occasionally the market overlooks details hidden in public filings. For instance, a Columbia value investing competition finalist highlighted that Jack-in-the-box owns Qdoba. Very few investors knew that at the time.

The market can be irrational in the short term. For instance, RIM was trading below net tangible assets (I am not 100% sure, but I think so) back in the summer. Unless you thought they would only burn cash going forward, it would have been a safe-ish buy.

Events also provide buying opportunities. Divestitures, mergers, restructurings etc. often create temporary mispricings. I'd suggest "How to be a stock market genius" for information here.

And for all of these, you need need catalysts (assuming your fund has a short time horizon). A stock can stay cheap (and just get cheaper) for years.

Even after all of this is said and done, basic multiples still work. If you created a fund of the bottom 20% of S&P 500 stocks based on normalized P/E ratios and P/B ratios, you would probably still generate (slight) outperformance relative to the index.

Best Response
Feb 28, 2013 - 11:21am

The cool kids all use the multiple approach, both relative and absolute. I generally look for a range of value that requires no major leaps of faith and that has a wide delta from the current valuation. But as I've been in this business for a while, I think valuation is actually less important than understanding what would cause the delta to close. If a stock is at $8.00 and I have reason to believe it's probably worth $15 - 20 subject to a variety of factors, I don't really care that much if my estimate of those factors is super accurate as long as I'm directionally correct with decent timing and the valuation is "accurate enough".

In other words, nailing the change / timing is usually more important than nailing the valuation as long as your valuation estimate is not ridiculous. I spend almost all of my time looking for the rerating potential because that is how you get paid. To oversimplify the explanation, I literally often will say, "The delta is approximately this wide, here's why the opportunity exists, here's why it will close -- and I'll probably make between x% and y% if I'm correct, and if I'm wrong, my downside is probably z%." I have literally never run a DCF on the buy side, and neither has anyone else I work with.

This is partly because I focus exclusively on small caps, many of which are not efficiently priced. The opposite is true for a large cap stock where there isn't likely to be dramatic rerating potential and where delta from fair value is likely to be a lot lower.

Feb 28, 2013 - 11:52am

Ravenous:
The cool kids all use the multiple approach, both relative and absolute. I generally look for a range of value that requires no major leaps of faith and that has a wide delta from the current valuation. But as I've been in this business for a while, I think valuation is actually less important than understanding what would cause the delta to close. If a stock is at $8.00 and I have reason to believe it's probably worth $15 - 20 subject to a variety of factors, I don't really care that much if my estimate of those factors is super accurate as long as I'm directionally correct with decent timing and the valuation is "accurate enough".

In other words, nailing the change / timing is usually more important than nailing the valuation as long as your valuation estimate is not ridiculous. I spend almost all of my time looking for the rerating potential because that is how you get paid. To oversimplify the explanation, I literally often will say, "The delta is approximately this wide, here's why the opportunity exists, here's why it will close -- and I'll probably make between x% and y% if I'm correct, and if I'm wrong, my downside is probably z%." I have literally never run a DCF on the buy side, and neither has anyone else I work with.

This is partly because I focus exclusively on small caps, many of which are not efficiently priced. The opposite is true for a large cap stock where there isn't likely to be dramatic rerating potential and where delta from fair value is likely to be a lot lower.

Also remember that, on a really fundamental level, a multiple is the inverse of a discount rate (well, actually a discount rate minus a growth assumption).

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Feb 28, 2013 - 11:48am

Never used a DCF on the buyside either. Ravenous is spot-on in terms of how I think the majority of the buyside looks to make money -- upside/downside, catalyst.

Most of the street will think in terms of a multiple on rev/EBITDA/EPS. If you really want to get deep, what is a multiple? It's a shorthand version of a DCF. What is ROIC > WACC and how long is it sustainable and how will that change. I doubt many people spend their time thinking about whether ROIC will decline in year 6 and to what degree, which is the same problem with a DCF - too many long term inputs which leads to garbage in, garbage out.

How to find mis-priced securities - experience. The longer you spend around names, the better your understanding of what fair value is for a stock or a business. Stocks tend to trade for similar multiples depending on the point in the cycle, over multiple cycles. So I look for what has changed or is going to change about that company specifically, and whether that is in the price. Or, I might have an out of consensus view on an upcoming trend (let's say I decide the housing starts are actually going back to 500k versus the consensus for near 1m) and identify the names with the most leverage / mis-pricing based on where I think consensus is wrong.

I've worked with or know investors who are more deep value focused. For them, screens tend to be a good starting point for identifying mis-priced stocks, although I would say that in most instances a multiple that looks low is low for a reason.

Mar 1, 2013 - 8:17pm

I suppose I'll provide the pro DCF answer.

I use DCFs all the time but they look quite different from the DCFs typically seen in the wild. If done correctly DCFs will help frame your bets and identify questions/issues that need the most attention.

Multiples methods are fine (I use them frequently as well) as long as you have a solid understanding of what those multiples are implying on a fundamental basis. (I'll actually distill many my DCFs down to a multiple since it's easier to communicate with Wall St. that way.)

That said, this business is full of buzzword bozos so take everyone's opinion with a grain of salt (including mine). Do your own homework and come up with the process that works best for you.

If you have a few minutes, I highly recommend reading "Common Errors in DCF Models". It help me become a more thoughtful analyst when I read it years ago.

http://www.cfainstitute.org/learning/products/publications/contributed/…

"Given that cash inflows and outflows are the lifeblood of corporate value, you might expect investors to be intent on measuring and valuing cash flows. Indeed, valuation in the bond and commercial real estate markets is all about cash. In practice, however, very few equity investors dwell on cash. Proxies for value, like earnings and multiples, dominate Wall Street valuation work.

Because markets are mostly efficient, investors can get away with using value proxies without awareness of what the proxies actually represent. The result is complacency and a false sense of understanding. As a consequence most investors don't do fundamental valuation work; when they do, they often do the work incorrectly.

First principles tell us the right way to value a business is to estimate the present value of the future cash flows. While most Wall Street professionals learned about discounted cash flow (DCF) models in school, in practice the models they build and rely on are deeply flawed. Not surprisingly, the confidence level in these DCF models is very low. This faint confidence is not an indictment of analytical approach but rather of analytical methods.

DCF models should be economically sound and transparent. Economically sound means the company's return and growth patterns are consistent with the company's positioning and the ample empirical record supporting reversion to the mean. Transparent means you understand the economic implications of the method and assumptions you choose. Most DCF models fail to meet the standards of economic soundness and transparency."

"Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple. Multiples are not valuation; they represent shorthand for the valuation process. Like most forms of shorthand, multiples come with blind spots and biases that few investors take the time and care to understand."

Jul 18, 2014 - 11:38am

Mr. Pink Money:

I suppose I'll provide the pro DCF answer.

I use DCFs all the time but they look quite different from the DCFs typically seen in the wild. If done correctly DCFs will help frame your bets and identify questions/issues that need the most attention.

Multiples methods are fine (I use them frequently as well) as long as you have a solid understanding of what those multiples are implying on a fundamental basis. (I'll actually distill many my DCFs down to a multiple since it's easier to communicate with Wall St. that way.)

That said, this business is full of buzzword bozos so take everyone's opinion with a grain of salt (including mine). Do your own homework and come up with the process that works best for you.

If you have a few minutes, I highly recommend reading "Common Errors in DCF Models". It help me become a more thoughtful analyst when I read it years ago.

http://www.cfainstitute.org/learning/products/publ...

"Given that cash inflows and outflows are the lifeblood of corporate value, you might expect investors to be intent on measuring and valuing cash flows. Indeed, valuation in the bond and commercial real estate markets is all about cash. In practice, however, very few equity investors dwell on cash. Proxies for value, like earnings and multiples, dominate Wall Street valuation work.

Because markets are mostly efficient, investors can get away with using value proxies without awareness of what the proxies actually represent. The result is complacency and a false sense of understanding. As a consequence most investors don't do fundamental valuation work; when they do, they often do the work incorrectly.

First principles tell us the right way to value a business is to estimate the present value of the future cash flows. While most Wall Street professionals learned about discounted cash flow (DCF) models in school, in practice the models they build and rely on are deeply flawed. Not surprisingly, the confidence level in these DCF models is very low. This faint confidence is not an indictment of analytical approach but rather of analytical methods.

DCF models should be economically sound and transparent. Economically sound means the company's return and growth patterns are consistent with the company's positioning and the ample empirical record supporting reversion to the mean. Transparent means you understand the economic implications of the method and assumptions you choose. Most DCF models fail to meet the standards of economic soundness and transparency."

"Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple. Multiples are not valuation; they represent shorthand for the valuation process. Like most forms of shorthand, multiples come with blind spots and biases that few investors take the time and care to understand."

I'm a huge proponent of this. I love Michael Mauboussin work on valuation.

I think the argument that DCF is silly so I used multiples is flawed. A multiple is short-hand for a DCF.

My preferred methods of valuation, in rank order, are:
1) Multiple of invested capital,
2) FCF yield, and
3) EV/EBIT (distant 3rd)

While I'm more unique in my process than other, I treat valuation as much of an input as I do an output. I think @"Ravenous" has it right by saying that you gotta focus on the direction of value rather than the precise calculation. Although I'm less "catalyst" minded than others. I think a cheap stock with proper capital allocation, almost by definition, "can't get cheaper for years and years". As an example, smart management can pull levels one may never think of. Its buying low, multiple junk businesses is what gets people in troubled..i.e., value traps.

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Mar 1, 2013 - 8:43pm

I rarely use DCFs, but the exception is when I'm looking at growth names. For those, DCFs can be sometimes be useful - though mostly instead I'll end up using just forward projections to 'normalized levels' and then putting a 'normal' multiple on earnings and discounting back at a random number that I pick (that usually just happens to be 10%).

I'll use multiples, but only to frame the potential return, not the likely one. It's hard to bet on multiple expansion and rerating (or contraction). Generally prefer to focus on fundamentals - if a company is going to beat expectations and make more money than people think, then I'm happy to buy it, especially if the multiple looks cheap. In that case, if the multiple expands, I'll make a lot of money, but if it doesn't, I'll still come out ok and make decent money.

In the worst case, you'll have companies that keep hitting your fundamentals but the market just doesn't care and the stock moves against you anyways, which is tough; but if you're right on fundamentals, still probably won't lose a lot. The fundamental I care about most varies on the situation, sometimes it's EPS, sometimes it's just top-line comp sales growth.

I don't like DCFs because I think that the CAPM is a load of crap, as is the terminal value assumption. So I prefer to just take whatever multiple the market is currently putting on a business and extrapolate it forward unless I really think there is a big value gap (like I mentioned above with lt forward projections). In general, I assume the market is rational so it's paying a multiple for a reason - really high multiples reflect strong growth expectations (typically, though for some names can just reflect inherent business stability), and low ones reflect earnings risk. Obviously these are all things you can also plug in to your DCF, but if your DCF comes out saying that the right multiple is 5x and right now the market is paying 9x, and the company keeps on beating expectations, the likelihood of getting paid being short that stock on multiple compression is probably pretty low.

Mar 2, 2013 - 12:07am

One of the interesting compromises I've seen people do is reverse-engineer a DCF to get the market price. So you look at different combinations of growth & margin assumptions to justify the market, and then focus your research on deciding whether to bet the over or under on those assumptions. It's obviously not a true intrinsic valuation, but it does help lay out exactly what's embedded in the current price & multiples.

Mar 2, 2013 - 11:12am

^Downtown hit the nail on the head. Especially for companies that are driven by one driver or a dominant driver (could be a operational metric, revenue CAGR going forward, etc), the reverse engineering method is fairly accurate is backing out what the market expects. You then do more analysis by either talking to mgmt, and/or expert networks to come up with your view of this metric. If your analysis says that for example gross margins will expand 250-300bps over the next couple years, calculate the valuation delta and there's your upside. This works great for pure plays.

For growth rate long term, i simply use ROE*(1-payout ratio) formula, where ROE is a sustainable figure. It is usually around 2% plus/minus 50bps (empirically from my analyses).

Also, going back to the OP: I find that the textbook version of a DCF is a little liberal. I do various additional adjustments to FCF. Also look at excess cash, cash taxes, etc. In the end, if a company is suitable for a DCF, then I end up doing a dividend discount. Basically pay out a big special dividend today (subjective depending on your view of how much cash the company needs), operate the company for a couple years, and start paying recurring regular dividends from then on based on the principle that the company does not need excess cash. You will find that usually this valuation is more accurate. The big assumption in a DCF is that Free cash flow belongs to shareholders and that they get it in that year. There is a BIG difference between that and when it is actually paid out (either via dividends or share repos, etc).

Disclaimer: buyside fundamental investor a big shop

Mar 6, 2013 - 1:23pm

Bot Some Calls:

Also, going back to the OP: I find that the textbook version of a DCF is a little liberal. I do various additional adjustments to FCF. Also look at excess cash, cash taxes, etc. In the end, if a company is suitable for a DCF, then I end up doing a dividend discount. Basically pay out a big special dividend today (subjective depending on your view of how much cash the company needs), operate the company for a couple years, and start paying recurring regular dividends from then on based on the principle that the company does not need excess cash. You will find that usually this valuation is more accurate. The big assumption in a DCF is that Free cash flow belongs to shareholders and that they get it in that year. There is a BIG difference between that and when it is actually paid out (either via dividends or share repos, etc).

Disclaimer: buyside fundamental investor a big shop

Great post - can you expand on this? Namely, what kind of adjustments to FCF you make, what kind of assumptions you make for how much and when the dividend is paid, and what the differences are between using FCF and dividends.

One of the industries I cover is very DCF-friendly (mining) and any way to make my models more accurate would be really helpful.

Jul 20, 2014 - 8:35pm

Bot Some Calls:

Also, going back to the OP: I find that the textbook version of a DCF is a little liberal. I do various additional adjustments to FCF. Also look at excess cash, cash taxes, etc. In the end, if a company is suitable for a DCF, then I end up doing a dividend discount. Basically pay out a big special dividend today (subjective depending on your view of how much cash the company needs), operate the company for a couple years, and start paying recurring regular dividends from then on based on the principle that the company does not need excess cash. You will find that usually this valuation is more accurate. The big assumption in a DCF is that Free cash flow belongs to shareholders and that they get it in that year. There is a BIG difference between that and when it is actually paid out (either via dividends or share repos, etc).

Disclaimer: buyside fundamental investor a big shop

The reason why valuation practitioners focus on free cash flows rather than dividends is precisely because most firms, with the exception of mature firms towards the end of their life cycle, do not pay out all that they can to shareholders in the form of dividends, buybacks etc.

The dividend payout ratio is rarely 1. Firms retain earnings in order to drive growth which, in turn, will lead to higher dividends in the future. In the long run, if you were able to correctly project a firm's FCF's and Dividends in perpetuity, you would achieve the same valuation result. If, on the other hand, you base your projections on dividends over a 5 year explicit forecast period, you're likely to severely undervalue the entity. Of course, this is also true for FCF/WACC DCFs, but to a lesser extent (which is why I prefer accounting based valuation models like RIV).

Without sounding too much like a dbag, and I don't want to paint too broad of a brush, most people on buy side don't have a strong grasp on theoretical finance and haven't been exposed to relatively sophisticated valuation techniques.

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Mar 7, 2013 - 8:40pm

@bonobochimp: the adjustments are more of a philosophical thing that goes to the heart of what free cash flow is. so look at line items in the CFS and IS and make adjustments (additions and subtractions) to get what cash is available (key word!) to shareholders. i am not being very specific because i think its a great exercise to do it yourself. Plus it is different with every company/industry (which have their own quirks). that's what they told me to do when i first joined.

for dividends, you want pay out as much as you can, being mindful of the industry. with more volatile businesses, i'd assume you need more of a buffer. i always look to comps for this payout ratio for a sanity check.

For miners, i'd really look at JVs, minority interests, etc.

Jul 20, 2014 - 8:37pm

That was fantastic.

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Jul 20, 2014 - 8:39pm

Never thought about valuation as broken down into those three separate categories. Interesting.

People tend to think life is a race with other people. They don't realize that every moment they spend sprinting towards the finish line is a moment they lose permanently, and a moment closer to their death.
Jul 20, 2014 - 8:42pm

There is no problem. The guy forgets that you can measure assets, by adding the sum of all assets, which is arguably hard OR by adding equity plus debt.So you take the market cap and add the value of its debt. Market Cap = share price times nr of shares and add stock options by using black scholes or a simpler method, such as the equity method. Also factor in convertibles and all that shit. The you add the value of the debt. A good proxy would be the book value of debt.
Done.

Jul 20, 2014 - 8:43pm

There's also something called the Clean Surplus Model, which is essentially a book value based approach + future growth options. It's an accounting-heavy approach, but together with the value of the growth option, you should yield a valuation that's fairly similar to the value of the firm using DCF.

Jul 20, 2014 - 8:44pm

yeah alright its a good video but its the only good one trust me. Once you subscribe to this overpriced service, you mostly get videos of interviews of some kids in china who cant speak english and who naively paid the ridiculous price they charge for individual mock interviews.
This service is SHIIIIIIIITT ! I subscribed and regretted. Now since its offered by WSO I expect my comment to be removed quickly by one of the admins of this site. But Im just trying to give an objective view on something this site certainly didnt do well.

DON'T BUY

Jul 20, 2014 - 8:53pm
LeYoun:
yeah alright its a good video but its the only good one trust me. Once you subscribe to this overpriced service, you mostly get videos of interviews of some kids in china who cant speak english and who naively paid the ridiculous price they charge for individual mock interviews.
This service is SHIIIIIIIITT ! I subscribed and regretted. Now since its offered by WSO I expect my comment to be removed quickly by one of the admins of this site. But Im just trying to give an objective view on something this site certainly didnt do well.

DON'T BUY

Okay I just re-visited the website and noticed it has been significantly improved since the time I wrote the comment above. I would therefore like to now recommend the service as the new videos are much more comprehensive and of much better quality. I also wanted to thank WSO for not removing my comment I truly appreciate the honesty and transparency of the team. They have worked really hard to improve their offering and to respond to customer concerns, and have made their service top notch

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LeYoun

Jul 20, 2014 - 8:46pm

Net Asset Value method and Cost Approach are the methods which he is referring to.

'We're bigger than U.S. Steel"
Jul 20, 2014 - 8:49pm

imo this is an extremely convoluted explanation (in general) for the valuation methodologies, and specifically determining the "market value of B/S assets (the basic concept is that anything you spend capex on which ends up sitting on the balance sheet has some "worth / value" because these "assets" will generate you future revenues)"

keep in mind the majority of ur target audience members are jrs in college, many of which have some or just a bit of finance experience. the terminology and phrasing used is simply too complex and not organized enough.

Jul 20, 2014 - 8:50pm
pokerdizzle:
imo this is an extremely convoluted explanation (in general) for the valuation methodologies, and specifically determining the "market value of B/S assets (the basic concept is that anything you spend capex on which ends up sitting on the balance sheet has some "worth / value" because these "assets" will generate you future revenues)"

keep in mind the majority of ur target audience members are jrs in college, many of which have some or just a bit of finance experience. the terminology and phrasing used is simply too complex and not organized enough.

Prob sufficient enough to get you through an SA or 1st year analyst interview.

'We're bigger than U.S. Steel"
  • 1
Jul 20, 2014 - 8:51pm

yes -- sufficient enough assuming you can process / understand what he says. a lot of folks just regurgitate without learning the fundamental concepts (which when explained properly are quite simple) --> this is a dangerous approach, but CAN work w/ time [typically you go through 5-6 rounds of rejections then your regurgitation is at a level where you've heard 90% of the questions asked so your "intuition" is at a point where you can pass through (but you're constantly paranoid--cuz you don't REALLY understand the concepts)].

but if you try to memorize and regurgitate how Joe walks through the main valuation methodologies i would imagine (i) most candidates will not be able to process what he is talking about (ii) throwing around big words that you do not fully understand will encourage interviewers to ask you tougher probing questions. I think the keys to success in interviewing are (i) guiding the interviewer to ask you technical questions you are most comfortable with (ii) explaining these concepts w/ simple terms that show your understanding and minimize the chance of nasty follow-up questions (iii) presentation -- not appearing like a pompous know-it-all when explaining answers you already know

on the video:

for instance, the "income approach uses some form of [capitalization of income] or discounting of cash flows...[productive asset] -- ? why would you ever explain it this way? and why would you throw in the capitalization of income?

in addition, many folks will confuse his "asset" valuation methodology with the "sum of the parts analysis", since Joe uses these terms interchangably. very few people use this approach in investment banking [maybe restructuring groups], and a "traditional" sum of the parts is MUCH more common. and again -- by throwing these terms at your interviewer [this approach in particular may even confuse the interviewer] you put yourself at a relative disadvantage

just my two cents....not to knock this program -- i think its net net great that WSO is setting up video training guides, etc.

Jul 20, 2014 - 8:52pm
pokerdizzle:
yes -- sufficient enough assuming you can process / understand what he says. a lot of folks just regurgitate without learning the fundamental concepts (which when explained properly are quite simple) --> this is a dangerous approach, but CAN work w/ time [typically you go through 5-6 rounds of rejections then your regurgitation is at a level where you've heard 90% of the questions asked so your "intuition" is at a point where you can pass through (but you're constantly paranoid--cuz you don't REALLY understand the concepts)].

but if you try to memorize and regurgitate how Joe walks through the main valuation methodologies i would imagine (i) most candidates will not be able to process what he is talking about (ii) throwing around big words that you do not fully understand will encourage interviewers to ask you tougher probing questions. I think the keys to success in interviewing are (i) guiding the interviewer to ask you technical questions you are most comfortable with (ii) explaining these concepts w/ simple terms that show your understanding and minimize the chance of nasty follow-up questions (iii) presentation -- not appearing like a pompous know-it-all when explaining answers you already know

on the video:

for instance, the "income approach uses some form of [capitalization of income] or discounting of cash flows...[productive asset] -- ? why would you ever explain it this way? and why would you throw in the capitalization of income?

in addition, many folks will confuse his "asset" valuation methodology with the "sum of the parts analysis", since Joe uses these terms interchangably. very few people use this approach in investment banking [maybe restructuring groups], and a "traditional" sum of the parts is MUCH more common. and again -- by throwing these terms at your interviewer [this approach in particular may even confuse the interviewer] you put yourself at a relative disadvantage

just my two cents....not to knock this program -- i think its net net great that WSO is setting up video training guides, etc.

I agree with most of what you are saying. IB does not really use asset based valuation and that is more of a restructuring or valuation approach rather than an approach used by IB. I dont see where the confusion would be with sum of the parts. It seems pretty clear in the video that he was referring to it on a replacement cost basis. I can see the confusion on the income approach, capitalization usually refers to capping one year of some type of economic income ( Cash flow, EBITDA, Etc.) with a cap rate vs a dcf which discounts the cash flows at a discount rate.

'We're bigger than U.S. Steel"
  • 2
Jul 20, 2014 - 8:54pm

Well depending on how much you read into the question I can think of at least 3 other methods that can be used to value a company.

The present value of all future expected dividends

The present value of future expected Abnormal Operating Income. In this method you take the book value of net operating assets plus the present value of future operating income minus the capital charge (wacc * BV NOA).

Alternatively the present value of future expected Abnormal Earnings. This is the book value of equity plus the present value of future comprehensive earnings (or net income if acounting is clean surplus) less capital charge (cost of equity capital * BVE).

Interestingly the last two methods are more accurate than the DCF method!

Jul 20, 2014 - 8:55pm

I was actually asked this question once.

My response was by looking at comparable companies or calculating the enterprise value of the firm. I gave a short reasoning for each. It was close to the idea to what this guy is saying but was NO WHERE near as elegant or complete. The interviewer seemed semi-impressed but now I'm guessing the guy was thinking "Ehh that was an ok response could have done better kid". I hate it when interviewers are not responsive. Sure they want to be nice but hey don't get my hopes up - although this is not a license to be a prick.

Mar 8, 2013 - 3:06pm

I haven't used a DCF to actually value something since college.... which will hopefully say something. How can one actually determine the proper discount rate, proper growth rate, etc. at year 5+ or 10+? Knowing how they all affect a multiple is really important, but knowing that lets say AAPL is going to grow at 5% versus 7% in 5 years in perpetuity.... is a pointless exercise IMO.

Ravenous gives a pretty good perspective around it. Looking for inflection points / timing is probably more worth your time (also hard as hell to figure out before the market). My favorite companies are ones in which
A. Market underappreciates growth potential b/c of major catalyst X (so EPS estimate too low)
B. EPS gets revised up eventually, along with growth estimates, so multiple gets rerated upwards too

Note that the above ones are also in the bucket of "very difficult to find before market". Most of the delta in EPS should hopefully come from understanding the stock/industry and its cycle better.

Mar 12, 2013 - 5:01pm

Very helpful responses guys.

"When you expect things to happen - strangely enough - they do happen." - JP Morgan
Jun 6, 2014 - 11:06am

I use DCFs or similar almost 100% of the time when evaluating liquid securities. The easiest manifestation of this is to just assume that the last year was the terminal year -- so I figure out unlevered FCF yield, perpetual growth rate estimate, and then compare those to/capitalize those at WACC to derive an EV and an equity valuation. This is very simple and often conservative for companies which are obviously cheap (i.e. double digit unlevered FCF yield; should clearly be growing in the future, even if at a snail's pace), and it's a hell of a lot more accurate/honest than picking an ebitda or earnings multiple from the ether, or comparing security A to securities B through F, any or all of which may be bad comps or mispriced. It also gives you a price point at which you believe you are earning a "market return," aka 0 alpha, which is when one should sell.

Whenever I communicate with other sophisticated investors, i just speak in FCF yields. When I communicate with LPs or credit folks, I speak in EBIT/EBITDA multiples.

In private deals I use and speak in EBITDA multiples but call out critical cash flow details (aka high roic, low capex requirements, big da-capex mismatch, etc). This is a longer conversation but it works when you are really just establishing a basis in something that you dont plan to trade for a long time, and the mutliple is obviously attractive, and the credit metrics work comfortably.

Jun 21, 2014 - 10:27am

DCF's are fine and all but sometimes you need to find a tether between stock prices and underlying enterprise value.

How do we tether the two?

1. Liquidation value. Closing shop, selling everything, and returning capital IS ALWAYS an option. Why go the trouble of discounting future cash flows when you can sometimes get a huge ass chunk immediately? This is your baseline value and provides a firm backstop to any sort of market irrationality.

2. Recap value. If a firm has no debt, $2 in cash, and a $5 credit facility that is untapped, I'd argue they firm is worth at least $7 since it can immediately special dividend that out. DCF might spit out something lower. Just ignore the DCF value.

In situations like these, I'd take Max(tether value, DCF value). This is probably more applicable to an activist manager since you can raid all these mispriced companies.

## Raid 4 Life.

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