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In Theory It Works...

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August 09, 2010 – Comments (0)

Some quick thoughts about discounted cash flows...

For those not familiar with DCFs, the very quick overview is that you're taking all the future cash flows of a company and discounting them back to what they're worth today (because a dollar tomorrow isn't worth as much as a dollar today) and using that to come up with a value for a company.

In the theoretical version of a DCF you do an academically-inspired calculation to come up with the "cost of equity." That cost of equity is very important as it's typically (at least for companies that are primarily equity-financed) a larger weighting in the overall cost of capital, which is what you're using to discount the cash flows.

Now if that sounds a bit like academic mumbo-jumbo it's because it is... well, to an extent at least.

Let's say you've run through a very complex DCF on BuddahBarn (an ueber-successful karma-oriented seller of farming equipment and attire) and have concluded that the stock is undervalued by 25%. Should you buy? Well, here's the other thing -- upon calculating BuddahBarn's cost of equity, you came up with 6%. So while you apparently have a 25% gulf between today's price and what the stock is theoretically worth, the bottom-line returns that equity-holders can expect are pretty darn low.

Now there's method to this madness and basically it's that theoretically a more volatile stock is a more risky stock to own, while a less volatile stock is less risky to own. In order to own the former, you need much higher equity returns than the latter. The problem, of course, is that the way that risk is measured -- volatility -- is, for lack of a better word, whack.

So what do you do? My answer is a bit of common sense. I generally start with a cost of equity (which we can probably also think of as an equity returns hurdle) of 12%. From there, I base my investment decisions on the price/valuation discrepancy and a consideration of the actual risk -- that is, potential for permanent loss of capital -- from the stock.

That would mean that I'd consider buying, say, McDonald's (which I do own) at a smaller discount than I'd demand for Blackstone (which I also own).

Another way to get around this cost of equity issue, is to not set a cost of equity at all. Instead, set all of your other variables, plug in today's price, and back into an implied cost of equity. Then -- again, based on actual risk for the stock -- decide whether that rate of return is really adequate compensation.

 

Matt

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