If you have enough foresight to build a reliable discounted cash flow (DCF) model, you probably don't need one.
Why is this important? Because true foresight is rare, and believing too much in one spreadsheet can lead to overconfidence. In reality, true investing success combines intelligence (analyzing) with wisdom (interpreting), the discipline of setting realistic expectations, buying at a reasonable price, and holding patiently until value accrues. It depends on exercising.
There is a fine line between confidence and arrogance, so above all, stay humble.
illusion of precision
A DCF valuation helps you understand how much your investment is worth today based on projected cash flows, adjusting for risk and time. For example, you expect an asset to earn $10 in cash flow in a year, but that is not guaranteed, and instead you have a safe annual rate of return of 5%. Discounting $10 by 5% gives a present value of approximately $9.50, which better reflects its true value (fair value) today.
But predicting these cash flows is like trying to predict the weather decades from now. All the detailed maps are available, but one unexpected “climate change” can disrupt the entire model. Similarly, in investing, global events, new competitors, or regulatory changes can overturn even the most scrupulous DCF assumptions, and how fragile long-term certainty really is. It makes it clear that there is.
The Terminal Value Trap: Why 80% of DCF Valuations Can Be a Mirage
A significant weakness of many DCF models is their terminal value, which is an estimate of a company's value far beyond the original forecast period. Terminal value often accounts for up to 80% of the total valuation, but terminal value is typically based on two major assumptions:
- The company will survive and prosper for decades.
- You, as an investor, will stay long enough to reap those profits.
Both assumptions deserve scrutiny. Approximately 10% of businesses in the United States go bankrupt each year, meaning that only 35% survive for a full 10 years. In other words, many companies never achieve rosy terminal value projections. Meanwhile, investor holding periods have shrunk from eight years in the 1950s to just three months in 2023. How valuable are these projections really if shareholders haven't been in the game long enough to earn distant cash flows?
Figure 1. Does DCF backload valuation make sense in a world of short-termism?
Source: Source: U.S. Bureau of Labor Statistics, NYSE, Barron's
When the DCF evaluation is off the mark
kodaka 140-year-old legend valued at $30 billion in 1997, seemed like a sure thing just looking at movie-based cash flow. A DCF in the early 2000s could have shown stable returns for many years to come. Instead, digital imaging soared in price at breakneck speed, and Kodak filed for bankruptcy in 2012. Here, the model's terminal value assumptions collided with rapid technological disruption.
blackberries I experienced a similar fate. By 2006, the company owned more than 50% of the smartphone market and was hailed as the “pioneering world leader in mobile texting services.” The DCF model may have factored in continued advantages over many years. But with the iPhone's debut in 2007 and BlackBerry's refusal to adapt, its market capitalization reached $80 billion in 2008 and would lose 96% of its value within four years. The once rosy bottom line turned out to be a mirage when new competitors rewrote industry norms.
In both cases, the assumption that these companies will remain competitive over the long term turns out to be a disastrous mistake, and if the industry changes direction faster than the spreadsheet predicts, DCF's valuation and reality This highlighted how the two can diverge.
DCF: Guiding principles, not blueprints
To be fair, some investors argue that even if the inputs to a DCF model are imperfect, you still need to take a disciplined look at a company's economics. That's a valid point, but for most stocks, especially in rapidly evolving sectors, DCF valuation is often a purely academic exercise divorced from the actual turbulence in the market.
Still, DCF has philosophical value, emphasizing the importance of cash flow to a company's health. However, identifying one precise target is like depicting a constantly changing landscape. Capture only a snapshot, not the entire panorama.
Is there a better way to value assets?
Rather than treating valuation as the final answer, think of it as a guide. In a world overflowing with data, we still lack the wisdom to know which information is most important. Markets can turn around in an instant, so a humble mindset is most effective. Explore industries with real upside, buy at deep discounts to various fair value estimates (rather than just one “magic number”), and continually refine your assumptions as conditions change. I will.
Although this article focuses on DCF valuation, keep in mind that there are other frameworks such as partial sums, residual returns, and scenario analysis. These provide additional perspective. There is no single formula that has all the answers.
Determining the possibility of the end of life with “realistic imagination”
Ultimate value is still important, but it works best as a qualitative marker rather than a strict metric. Think of this as “realistic imagination.” Assess how sectors and products will evolve, consider whether consumer needs and the regulatory environment will change, and assess a company's adaptability. Envisioning multiple possible futures, rather than a spreadsheet scenario of “everything goes well,” helps prevent overconfident predictions.
Identify the winners: Know what to pay for
Once you've identified sectors with true long-term potential, the next step is to determine which companies can withstand changing market conditions.
When trying to assess a company's long-term potential by going beyond a single valuation model, always ignore short-term market noise and focus on the common characteristics of companies that drive lasting results. That helps. Amazon, Apple, and Tesla serve as prime examples of how these characteristics manifest in the real world.
Figure 2. Common DNA of Amazon, Tesla, and Apple
Source: Company website and annual report
Just as investors can benefit by taking a long-term view and maintaining a margin of safety while taking calculated risks, companies that do the same are more resilient in the face of economic downturns. can often be maintained. But even powerful brands like Amazon, Telsa, and Apple could face a “Kodak moment” if they drop the ball and lag behind in staying relevant.
Identify the winners: Know how much to pay
Before delving into the quantitative framework, it is important to agree on the psychological framework. The key elements of a healthy psychological framework are:
- Operating cash flow (OCF) should be your number one investment screen.
- If a company cannot generate enough OCF to cover day-to-day expenses, hold off.
- Although they may give up the most initial upside, once a quality company reaches breakeven OCF, there is still plenty of upside left without the existential risk of permanent capital loss. Masu.
- Returns are not high enough to justify investing in a company that cannot finance its own operations.
Figure 3.
All assets have a rough “fair value.” The key is to buy below that threshold. We all have limited visibility into the distant future, so attempting to make predictions over very long periods of time can be foolhardy. Instead, we focus on companies in sectors with sufficient runway and aim to estimate realistic “normalized cash yields.”
What is “normalized cash yield”?Let's consider a simple analogy. A bank deposit with an interest rate of 5% yields a predictable “normalized cash yield” of 5%.
With stocks, the yield is not guaranteed. You need to estimate the amount of cash a company can realistically generate over a business cycle (usually a three- to four-year cycle) and compare that number to current market valuations. In financial terms, it calculates the average cash yield over a three to four year period. If this yield exceeds the cost of capital and other available investments, taking into account differences in growth prospects and transaction costs, you have built a margin of safety in your investment.
Think longer: Build a focused and resilient portfolio over time
In today's fast-paced trading environment, many investors seek short-term gains from multiple expansions by redistributing value rather than creating it. Not everyone can invest for decades, but a five-year time horizon is often optimal. It provides enough time for the real fundamentals to shine through, reduces the noise of daily price movements, and allows compound interest to work its magic.
100 years of historical S&P 500 data backs this up. Generally, a longer holding period provides a better balance between risk and return. Time acts as a powerful filter, smoothing out short-term volatility that can prematurely derail a promising investment.
Figure 4. 100 years of S&P 500: holding period and risk/return relationship
Source: S&P, Bloomberg
Important points
While DCF valuations offer an appealing sense of numerical clarity, 80% of their “value” can be based on uncertain final assumptions. It's certainly easy to break. True investing success usually comes from a balanced approach that includes a combination of informed imagination, disciplined portfolio construction, and plenty of time to let compound interest take hold. By focusing on companies that truly generate cash flow, buying companies at fair prices, and being patient, you won't need clairvoyance to build a portfolio that's ready to weather market storms.
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