In the article Assign Yourself the Right Story, Geoff Gannon spoke out against DCF (discounted cash flows):
When you go racing off to do a DCF you are doing a lot more than you think. There are a lot of assumptions in doing a DCF – including the very big assumption that a DCF will give you the most useful estimate of a company’s value.
His solution to the whole dilema is:
There’s a much simpler way to invest. Look at your choices. Buy the stock that is:
· Clearly undervalued
· You are most comfortable owning
· And offers the best annual return on your investment
I would like to add another point that Taleb brings up: the notion of "fragility". The basic problem with DCF – and the ultimate reason as to why you should never do them – is fragility. I would go so far to say that if you perform a DCF calculation (other than for bonds, where you actually know the cashflows), then you are pursuing an inherently flawed investment process.
The problem with DCF is that it is very sensitive to discount rates, growth rates, and a host of other assumptions. Although Taleb didn’t discuss DCF specifically, he is keen that we look at the robustness of our processes. Taleb offers a way to test the fragility of our models. It is this: perturb the assumptions slightly. Perturb the model on the "downside", and on the "upside". If the downside change is more than the upside change, then you know you have a fragile model. Things are likely to work out worse than you expected – possibly much worse – because you get punished disproportionately more when things go wrong. It probably means that things will go wrong.
Taleb offers a way of looking at assumptions that is quite far-reaching; it almost seems like he’s hit upon a cosmic law. I’ll offer a very personal example.
About 6 months ago, the company I work for moved to new, bigger, flashier premises as part of a process of consolidating. Sister companies will, soon enough, be moving to those premises. The premises are in the process of being expanded. This brought up the whole question of car parking. There was a lot of worry about the existence of sufficient capacity amongst other tenants – a worry that I share, by the way. I overheard my office manager talk about how they had been looked into the question of car parking, and had factored in assumptions about car sharing and the use of public transport.
As soon as I heard that, I thought of Taleb. I realised that we were probably doomed as far as car parking was concerned. There are asymmetries in the way the payoffs work.
I’ve got a few more examples of biases in modelling, groupthink, and rationalisation, but I’ll save them for a future post.
In the meantime, happy investing!
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