Value Investing: Tools and Techniques for Intelligent Investment

Chapter 5. The Dangers of DCF^[5]

Theoretically, discounted cash flow (DCF) is the correct way of valuing an asset. However, as Yogi Berra noted, 'In theory there is no difference between theory and practice. In practice there is.' The implementation of a DCF is riddled with problems. First off, we can't forecast, which kind of puts the kibosh on the whole exercise. Even if we choose to ignore this inconvenient truth, problems with the discount rate still make a mockery of the whole idea of DCF. No wonder DCF has such a poor reputation. The good news is that several alternatives exist. We explore three that avoid forecasting altogether!

• While the algebra of DCF is simple, neat and compelling, the implementation becomes a minefield of problems. The problems can be grouped into two categories: problems with estimating cash flows and problems with estimating discount rates.

• One of the recurring themes of my research is that we just can't forecast. There isn't a shred of evidence to suggest that we can. This, of course, doesn't stop everyone from trying. Last year, Rui Antunes of our quant team looked at the short-term forecasting ability of analysts. The results aren't kind to my brethren. The average 24-month forecast error is around 94%, the average 12-month forecast error is around 45%. My work on long-term forecasts is no kinder to the analysts: they are no better at forecasting long-term growth than they are short-term growth.

• Even if we ignore the inconvenient truth of our inability ...