Dcf’s/models – frameworks for abstraction

I quite often hear people commenting negatively about dcf’s, but really a critique of dcf’s needs separating into two parts. To me, the theoretical framework is something that no analyst can do without (it IS valuation). The practical application is different, with inputs often manipulated to justify pre-conceived valuations, but this is true with or without the application of a dcf, and the fault is not simply in the discount rate, but the mix of inputs (simply place a PE across over-optimistic earnings forecasts and the problem is the same). With any model or assessment tool, the old cliché applies – ‘rubbish in, rubbish out’, whether that be top-line, margin (profit), cash conversion/not adjusting for weak accounting policies, or discount rate.

I saw the comment below today (1/11/17) and think it captures the situation well. It reminds me of a superb fund manager I know (he subsequently crossed to the sell-side as a strategist), who once, when talking about the then trend for EVA analysis, said ‘what’s wrong with a P/E‘, meaning that if you know your stuff (what is the income recognition policy, growth, cash conversion, moat/RoI/margin etc.), you should pretty be able to work back from a P/E … . and, of course, on the theme of ‘working back/inverting’, reverse dcf’s are used by many – what mix of inputs is needed to justify the current valuation?

This puts it much better than me*:

‘… just like DCFs (which is a tool Buffett is skeptical of in practice, despite agreeing with the general method in principle),

Buffett and Munger essentially do the cost of capital calculation in their head. They implicitly use and understand both DCFs and cost of capital calculations even if they don’t explicitly label them …‘

* Thoughts On Cost Of Capital And Buffett’s $1 Test – Part 1; John Huber; Value, long-term horizon, special situations, Saber Capital management https://seekingalpha.com/article/4118943-thoughts-cost-capital-buffetts-1-test-part-1

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