Issues with DCF Analysis

The DCF method is perhaps one of the most trustworthy approaches for determining the intrinsic value of a company's stock. However, the DCF approach has a number of disadvantages that you should be aware of. The DCF model is only as accurate as the input assumptions. If the underlying assumptions are erroneous, the computation of fair value and stock price could be affected.

1. DCF requires us to forecast - The DCF model requires us to forecast future cash flows and business cycles as a prerequisite. This is a challenge not only for fundamental analysts but also for the company's executive leadership.

2. Extremely sensitive to the Terminal Growth Rate - The DCF model is extremely sensitive to the terminal growth rate. A little adjustment in the terminal growth rate would have a significant impact on the ultimate production, or per share value.

3. Constant updates - Once the model has been constructed, the analyst must adjust and align it with fresh data (quarterly and yearly data) as it becomes available. Both the inputs and the assumptions of the DCF model must be routinely updated.

4. Long-term focus — DCF is mainly focused on long-term investing, and as a result, it offers little to short-term investors. (i.e. investment horizon of one year)

In addition, the DCF model may cause you to lose out on unique chances because it is built on strict criteria.

That being said, the only approach to overcome the shortcomings of the DCF Model is to be as cautious as possible when making assumptions. The following are some recommendations for conservative assumptions:

  1. FCF (Free Cash Flow) growth rate - The annual growth rate of FCF must be approximately 20%. Companies can hardly sustain free cash flow growth above 20%. If a company is young and in a high-growing industry, an FCF growth rate somewhat below 20% is certainly acceptable, but no company deserves an FCF growth rate greater than 20%.

  2. Number of years – This is a bit tricky, while longer the duration, the better it is. At the same time longer the duration, there would be more room for errors.

  3. Terminal Growth Rate – As I had mentioned earlier, the DCF model is highly sensitive to the terminal growth rate. Simple thumb rule here – keep it as low as possible. I personally prefer to keep it around 4% and never beyond it.

Margin of Safety

Now, despite having made some safe assumptions, there is still the possibility that anything could go wrong.

How do you defend yourself against it?  This is where the "Margin of Safety" concept comes in.  In his classic work "The Intelligent Investor," Benjamin Graham popularized the margin of safety concept. The 'margin of safety' advises that an investor should only purchase equities when they are available at a discount to their estimated intrinsic value. Adherence to the Margin of Safety would not guarantee financial success, but it would give a cushion for calculation errors.

Here is how you can exercise the ‘Margin of Safety’ principle in your investment practice. Consider the case of Company X mentioned in the previous chapter; the intrinsic value estimate was around BDT 95 per share. Further we applied a 10% modelling error to create the intrinsic value band. The lower intrinsic value estimate was BDT 95/-. At BDT 95, we are factoring in modelling errors. The Margin of Safety advocates us to further discount the intrinsic value, let’s say by another 20%.

But why should we discount it further? Aren’t we being extra conservative you may ask? However, this is the only way to protect yourself from incorrect assumptions and poor luck. Considering all the criteria, if a stock appears lucrative at BDT 100, then for BDT70, you can be convinced that it is definitely a smart investment! This is the standard practice of experienced value investors.

When the price of a high-quality stock falls substantially below its true worth, value investors will purchase it. Consequently, when the margin of safety is at stake, you should consider purchasing the asset as quickly as possible. As a long-term investor, such enticing opportunities (such as a solid stock trading below its real value) should not be overlooked.

Also, remember that good stocks will be offered at steep discounts during a bear market, when people are highly negative about the stock market. During bad markets, you should ensure that you have enough cash to make purchases.

When to sell?

Throughout the module we have discussed about buying stocks. But what about selling? When do we record our gains? Assume, for example, that you purchased shares of business X at about BDT 100 each. Currently, it is trading for about BDT 178/- per share. Does that imply that you will actually liquidate this stock and record a profit? So does that mean you actually sell out this stock and book a profit? Well the decision to sell depends on the disruption in investible grade attributes.

Disruption in investible grade attributes – Keep in mind that choosing to purchase a stock has nothing to do with the price at which it is now trading. In other words, just because stock X has dropped by a particular percentage, we won't buy it. We buy stock X only because it qualifies through the rigor of the “investible grade attributes.” If a stock doesn't exhibit qualities that are of investible grade, we won't buy it. Therefore going by that logic, we hold on to stocks as long as the investible grade attributes stays intact.

The company might continue to exhibit the same qualities for many years. As long as the characteristics remain unchanged, we will continue to own the shares. By virtue of these characteristics, the stock price appreciates automatically, generating wealth for you. When these characteristics begin to deteriorate, one may consider selling the stock.

How many stocks in the portfolio?

The required amount of stocks in a portfolio is frequently the subject of discussion. While some argue that holding a large number of companies allows you to diversify risk, others argue that keeping a much smaller number of stocks enables you to make concentrated bets that have the potential to generate substantial returns. Here are some of the renowned investors' recommendations regarding the quantity of equities in your portfolio:

  • Seth Kalrman – 10 to 15 stocks

  • Warren Buffet – 5 to 10 stocks

  • John Keynes – 2 to 3 stocks

While it is hard to comment on what should be the minimum number of stocks, there is no point owning a large number of stocks (say over 20) in your portfolio.

Final Conclusion

Over the last 16 chapters, we have learnt and discussed several topics related to the markets and fundamental analysis. Perhaps it is now the right time to wrap up and leave you with a few last points that I think are worth remembering –

  1. Be reasonable – Markets are volatile; it is the nature of the beast. However, if you have the patience to stay put, the market can be rather rewarding. “Rewarding" implies a CAGR between 15 and 18 percent. Please do not be fooled by exceptional short-term returns of 50 to 100 percent. Even if they are attainable, they may not be sustainable.

  2. Long term approach – Remember, money compounds faster the longer you stay invested

  3. Look for investible grade attributes – Look for stocks that display investible grade attributes and stay invested in them as long as these attributes last. When you believe that a company no longer possesses these qualities, sell the stock book your profits.

  4. Respect Qualitative Research – Character is more important than numbers.

Always look at investing in companies whose promoters exhibit good character.

  1. Cut the noise, follow the checklist – No matter how much the analyst on TV/newspaper brags about a certain company don’t fall prey to it. You have a checklist, just apply the same to see if it makes any sense

  2. Respect the margin of safety – As this literally works like a safety net against bad luck

  3. IPOs – Avoid investing in IPOs. IPOs are typically priced too high. However if you were compelled to buy into an IPO then analyse the IPO in the same 3 stage equity research methodology

  4. Continued Learning – Understanding markets requires a lifetime effort. Always look at learning new things and exploring your knowledge base.

To conclude, here are four book suggestions that can help you develop an excellent investment mindset.

  1. The Essays of Warren Buffet : Lessons for Investors & Managers  

  2. The Little Book of Valuations – By Aswath Damodaran

  3. The Little Book that Builds Wealth – By Pat Dorsey