The juicy part of this article is at number 2. Skip there to see how the market’s intrinsic value adjusts due to a change in discount rates, and how the market weighs present values that occur before and after 10 years for both growth companies and value companies.
As you can see in the graph below, humans have become better at forecasting the weather as technology has progressed. We can now predict weather 3-days out at an accuracy rate of above 95%, we can predict the weather 5-days out at an accuracy of rate almost 90%.
Unfortunately the further out we go, just 10-days in the future, the less reliable our forecasts become.
Forecasting a company’s cash flows is similar to forecasting the weather. Cash flows that come earlier (1 to 10 years in the future) are more reliable. The further out these cash flows are, the more they are susceptible to changes in the business environment.
When you run a discounted cash flow analysis on a growth company that has a high valuation, you will find (as I will show you) that the majority of a company’s current market capitalization is dependent on cash flows that occur very far out. They are highly susceptible to a changing business environment. It makes forecasting for them very difficult, and it increases the risk of the investment.
This article proposes to do a few things:
Explain why discounting cash flows is more of an art than a science.
Demonstrate that for highly-valued companies, the market gives more credence to cash flows that occur very far out in the future when the market as a whole evaluates a company. And vice-versa, the market gives credence to near-term cash flows for a value company.
Describe how highly-valued growth companies are extremely sensitive to changes in the discount rate (opportunity cost/required return) compared to value companies. (how to think about margin of safety, real risk (not beta), and investments in general)
Buffett: in order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value — in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.
1. Why discounting cash flows for equities is more of an art than a science
Munger: Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea.
Buffett: It’s true. If [the value of a company] doesn’t just scream out at you, it’s too close.
The reason Buffett doesn’t actually do a DCF (discounted cash flow) analysis is that it should be so obvious that you don’t need to do one, and if you were to do one, it would obviously scream “invest”. When you’re looking at equities, the present value of the cash flows (intrinsic value) needs to be MUCH bigger than the market capitalization of the stock/equity for you to be close to certain you’re making a good investment.
A - discounting cash flows for risk-free government securities is easy because we know:
When the cash flow will come
What the cash flow will be
What the discount rate is for that cash flow
B - discounting cash flows for equities is much harder because:
We can’t time the cash flows accurately (the business world changes extremely fast)
The cash flows could change drastically in amount
The discount rate is subject to the analyst’s expectations
This is why investing in equities is more of an art than a science. The investor’s job is to absorb as much information as possible from available sources to reduce the degree of uncertainty about points 1 and 2 above. The closer the investor can get to reality, the more accurate the DCF analysis is. The more accurate the DCF analysis is, the higher the probability the investor has of being right about an investment.
The investor’s main job will be to reduce the margin of error of the assumptions (point 1 and 2) by absorbing information outside of the financial statements. This means the investor must understand the business, know the management, know the market and know the competitors…all in an effort to become more certain of those cash flows and of the applicable discount rate (discount rate - opportunity cost) of the cash flows.
The “discrepancy” between what you calculate as intrinsic value and market value is margin of safety. As Buffett states, this discrepancy needs to be so big it needs to “SCREAM at you” because the assumptions used in the discount rate can change the intrinsic value of an investment by a lot. What he means is that the discrepancy between the intrinsic value you calculate - and the current market capitalization of the company - needs to be so big that the market has obviously missed something. It must give you a big margin of safety so that even in the worst-case scenario you still may not lose on the investment if you’re investing over a long time frame.
2. Why highly-valued growth companies are inherently more risky (at higher prices) compared to value companies
Much like the weather, far-out future cash flows are harder to estimate. Are growth companies’ market capitalizations more sensitive to changes in interest rates?
We need to conduct a little Discounted Cash Flow model experiment (if you want access to this simple model, do email me). We want to understand:
What portion of a company’s market capitalization is coming from present value cash flows before 10 years and what portion of market cap is coming after 10 years. In other words, what does the composition look like?
How changes in the discount rate affect highly-valued growth companies compared to companies considered value companies.
We’re going to use two real-life companies in our example.
Highly-Valued Growth company (trading at high multiples): Apple will be used as our “Highly-Valued Growth Company”, even though Apple’s growth has slowed down, it’s still priced at very high multiples (as if the market expects growth for a long time).
Value Company (not trading at high multiples): For our value company we are going to look at Aaron’s company, I did an analysis on it previously, and it’s pretty easy to understand and it trades at value. Not really growing much either, but the balance sheet is strong (no debt). And they make a decent profit.
In the Discounted Cash Flow model, I made the current market cap equal to my intrinsic value. I do this because I want to understand what the market as a whole is expecting from future growth rates for these two companies. It works by changing the growth rates until the intrinsic value equals the market cap. This is actually called a ‘reverse (engineered) discounted cash flow’. And it can imprecisely give us one solution to the market’s expected growth rate.
What does the composition of present value cash flows look like?
Keep in mind that the sum of these present value cash flows equals the intrinsic value of the company. Therefore, because we used a reverse-discounted cash flow analysis we can understand how the market is discounting Apple. We’ve used the market cap of Apple to work backward to find the growth rates (Figure 1.) associated with that market cap or the growth rates the market expects from Apple (this is one of those combinations of growth rates). The majority of Apple’s intrinsic value (as perceived by the market) comes from discounted cash flows after 16 years (see below Figure 2). What the market is saying is that it thinks Apple is an extremely strong company, that it will survive for many years and continue to grow (the market is very possibly correct to think this).
Note: the sum of these present values below equates to the market cap of the company at the date I did this analysis (it could have changed a bit since).
Notice the way this graph curves (Figure 2). Most of Apple’s market capitalization is based on the cash flows it receives after 16 years into perpetuity. Compare this to figure 4 below - Aaron’s company
Then we have Aaron’s company. The market is discounting the company quite harshly. For me to get to the market capitalization of Aaron’s company, I needed to use the following growth rates:
These are not my assumptions. This is what I needed to use to get to the market capitalization of Aaron’s company. This is what the market is expecting for Aaron’s company.
It’s quite interesting to see because Aaron’s company’s cash flows haven’t been declining as fast as the market expectations suggest they will. There are many reasons why a stock could be pessimistically valued like this, one reason could be because the company is boring.
This should be exciting for you to see - it shows that the most important cash flows for Aaron’s company are the cash flows that will be received in the next 10 years. It also means that the market doesn’t really expect Aaron’s company to survive long-term.
An investor’s job would be to ask if the market’s assumption of these growth rates (or decline) is too pessimistic or too optimistic. The investor’s job is to do research into the company and ideally first value it based on their own assumptions. After which they can decide whether the market is wrong or right.
Remember, just like the weather, near-term cash flows are easier to forecast. This is one of the reasons why growth companies can be dangerous. A lot can change in 20 years - enough change can happen to disrupt an entire industry.
How changes in the discount rate affect highly-valued growth companies compared to companies considered value companies.
Intrinsic value decline based on a 1%, 2% and 5% increase in discount rates. Apple - blue, Aaron’s company - orange.
This shows that highly-valued companies, which have most of their intrinsic value (according to the market) coming from cash flows far into the future, are most sensitive to changes in interest rates.
A 2% increase in discount rates, that could come via rate hikes, increased risk perception, or even a change in creditor ratings could be catastrophic to a highly-valued company from a valuation perspective.
Furthermore, for highly-valued companies, the market generally prices in a rosy picture of the future for the company, compared to the pessimistic outlook we see for value companies (like Aaron’s company). This leaves a wonderful gap in value in discounted cash flow analyses.
Once we’re comfortable with our own measurement of intrinsic value for a company - and we believe the market is pricing it at a significant discount to our calculated intrinsic value - it may warrant investment. The most important thing is that the gap between our calculated intrinsic value and the market cap should be large enough that it provides us with a proper margin of safety so that even in the worst-case scenario we still get out fine.