The value of any asset is the sum of its future cash flows discounted to present value. People make investments to generate more money in the future. The ‘more money’ is future cash flows.

No one would buy an asset that will generate $10 in future cash flows for $20. You would lose money. An asset that produces $10 in future cash flows must (or rather, should) trade for some price below $10. The lower, the better for investors.

The Present Value of Bonds

The present value of bonds are easier to calculate than that of stocks. The amount of each payment is known. The timing of each payment is also known. With a 10 year bond yielding 5%, you know you will get 5% of the bond’s par value every year. On the 10th year, you will get the bond’s full par value.

The Difficulty of Finding a Stock’s Present Value

Stocks are more complicated. If you owned a business outright, the present value would be the sum of the business’ future earnings discounted to present value using an appropriate discount rate. Fractional ownership (stock ownership) of a business is no different. The value of a stock is the present value of its future earnings.

To calculate the present value of a stream of future cash flows you need 3 things:

  1. When the earnings stream will start and stop
  2. The growth rate
  3. The discount rate

There are several problems in practice with finding the present value of a stock.  These issues are discussed in the sections below.

Problem #1: When will earnings stop?

No business lasts forever. Some businesses last longer than others. Insurers in particular have very long life spans while tech companies tend to have very short life spans.

Since no business lasts forever, using a perpetuity model to value a business is not reasonable. Instead, the amount of time the business will last must be guessed at. If a business is valued as a perpetuity and the company has a higher growth rate than discount rate, the discounted cash flow method would return an infinite value of a business. If you believe a company can have an infinite value, I have some shares to sell you for a very ‘low’ price…

No one knows in advance when a business will stop producing earning and fold. This makes finding the value of a stock an inexact science.

Problem #2: What is the appropriate growth rate?

In addition to the issue of not knowing how many years a stock will produce earnings, no one knows the appropriate growth rate to use.

Will Coca-Cola grow earnings-per-share at 7% a year, 8% a year, or some other number? The farther into the future earnings are projected, the less accurate the projection.

Problem #3: What is the appropriate discount rate?

The appropriate discount rate to use is dependent upon the risk of not receiving cash flows in the future. The more certainty one has about the accuracy of the growth rate and the longevity of the business, the lower the discount rate.

At a baseline, the discount rate must be above the 30 year treasury rate. Stocks are long-term investments – if things go well, a business will be generating cash flows for you at least 30 years into the future. The 30 year treasury rate shows the return investors are willing to take in a ‘riskless’ 30 year investment. The U.S. treasury is seen as riskless (in reality, nothing is truly riskless) because the U.S government has the power to tax its citizens and create money – virtually guaranteeing the bonds will be repaid.

There is no business with the ability to print money or take money from anyone they want (taxes). As a result, all businesses are at least somewhat riskier than the 30 year treasury rate. The discount rate used must be higher than the 30 year treasury rate. How much higher depends on the risk of the business.

Finding an appropriate discount rate is more art than science, there is no ‘right’ answer.

Why I Don’t Use Discounted Cash Flow Analysis

I agree with the ideology behind discounted cash flow analysis. I don’t, however, use it in practice. There are far too many variables for discounted cash flow analysis. Being off on a company’s growth rate by 1 or 2 percentage points can cause a dramatic shift in the long-term value of a business.

Discounted cash flow analysis relies on a host of assumptions. These assumptions are really what one is basing their investment on. The formulaic approach of discounted cash flow analysis puts a number behind these assumption.

The appeal of discounted cash flow analysis is that it provides a fair value for stocks. The formula creates precise ‘fair values’ for any business with positive earnings. This gives investors a false sense of security. Just because a number is difficult to calculate does not mean it is accurate. An accurate estimate of fair value requires deep understanding of the risks and growth prospects of a business.

Rank Versus Fair Value

It is impossible to know the true fair value of any business. What we can know is that a business is currently cheaper/more expensive based on earnings than another business, has grown faster over the last 10 years, or has maintained a lower stock price standard deviation. Comparing businesses to each other shows us where businesses rank relative to one another.

This type of analysis does not rely on finding a precise value for a business. Rather it takes a look at what has historically worked in investing and ranks stocks over these categories.

Well thought out ranking systems have historically performed well. Benjamin Graham advocated buying businesses with a price lower than net current asset value. Specifically, businesses trading at 2/3 of net current asset value – the lower the better. This involves ranking all businesses over just 1 criteria (net current asset value) and buying the cheapest.

Joel Greenblatt’s Magic Formula takes a similar ranking approach – ranking stocks on EBIT/Enterprise Value and on return on capital. The Quantitative Value approach by Tobias Carlisle and Wes Grey also uses a ranking system rather than estimating fair values.

The 8 Rules of Dividend Investing applies a rule-based ranking approach to high quality dividend stocks. Each of The 8 Rules of Dividend Investing rank dividend stocks with 25+ years of steady or rising dividend payments over criteria that have historically reduced risk or increased returns.