DCF and fragility

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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About mcturra2000

Computer programmer living in Scotland.
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5 Responses to DCF and fragility

  1. Wexboy says:

    Agreed! Reminds me of two Buffett related quotes:

    Buffett: ‘Rather be approximately right than precisely wrong.’

    Munger: ‘I don’t know. We have such a fingers and toes-style around here. Warren often talks about these discounted cash flows, but I’ve never seen him do one.’

  2. Penman also has an interesting perspective on the danger of DCF, when building a valuation an investor should always be distinguish between what he knows and speculation. DCF conflates them (in fact its almost entirely speculation – the cost of capital… future cashflows…), which is why a DCF calculation is both fragile and usually precisely wrong.

    • Calum says:

      The other interesting thing from Penman was his point about a company with a lot of capex requirements. The company will have negative FCF so it will be impossible to value without a long long forecast period but it could be investing that money in a really great business (in the textbook, I believe the example is SBUX). I use models quite a bit but I find the DCF just doesn’t really work for any company other than FCF monsters with average returns on marginal invested capital.

      I would say though that if your careful (and do a bit of reverse engineering) they aren’t too bad.

      • Yes, I’ve just got to that bit in ‘Accounting for Value’. It’s going to be a very hard book to review. Totally fascinating, but I’m not sure whether it will take me anywhere… I have a horrible feeling at the end of it I’m going to think that valuing the speculative element of a business is just too hard and default to a no growth scenarios where book value looks relative solid!

  3. John Kingham says:

    The notion of fragility and robustness have become a key part of my investment process over time. The more time I spend investing the more I see that the future is a very unknowable place, so protecting myself against the future has become the most important thing, followed some way behind by beating the market.

    It’s no good beating the market for 10 years straight only to lose 80% of your money in year 11 and sell out in a panic.

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