Equity Research for Value Investing 1

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Despite many of the negatives that we hear about DCF-based stock valuation these days, it is still a mainstream method for stock valuation as part of fundamental equity research. In his 1992 Berkshire Hathaway (BRK.A) annual report concerning the DCF stock valuation method, Warren Buffett stated "In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset." Many of the popular stock market report bands equity analysis resources that retail value-investors rely on utilize this stock valuation method. This article will examine the strengths and weaknesses of DCF-based intrinsic value calculations and why it is importing for value investing.

Let's review the main weaknesses of DCF-based stock valuation.

The first is that it requires us to predict cash flows or earnings long into the future. Data shows that most equity analysts cannot predict next-year's earnings accurately. On a macroeconomic level, the "experts" have a terrible track record in predicting jobless claims, the year-end S&P, or GDP. This is no different when it comes to projecting the future cash flow of a business when picking stocks. We have to admit to ourselves that we have tremendous limitations in the ability to forecast future cash flows based on past results and recognize that a small error in the forecast can result in a large difference in the stock valuation.

The second challenge is determining the appropriate discount rate. What is the discount rate? Should we dust off our college or graduate school notebook and look at the CAPM, which calculates the discount rate as the risk-free rate plus the risk premium?

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Well, since this I learned this formula from the same guy (by business school finance professor) that convinced me as a 22-year old, wet-behind the ears student that markets are efficient, I am skeptical. The most famous value investor Warren Buffett's public comments about the issue have evolved as he has stated that he uses the long term US treasury rate since he tries "to deal with things about which we are quite certain but reminded us in 1994 that "In a world of 7% long-term bond rates, we'd certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we're willing to play." I'm inclined to take these seemingly contradictory guidelines from Buffett and from there derive a reasonable estimate of the discount rate as part of my stock research. With the September 1, 2011 30-Yr treasury yield at 3.51%, we must think that our discount rate for large cap stocks is closer to 10% than to the risk-free rate.
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