The evaluation method is in the eye of the beholder

Mr. Market¹ has been particularly indecisive lately as price volatility has caught the attention of many investors.

Friday, May 5, 2023 at 12:11 PM

Mint Asset Management

Sam Arkand

As an active manager focused on producing better risk-reward outcomes than the overall market, Mint believes investors should continue to pay attention to value and try to ignore price movements. increase. To help investors maintain their focus, we wanted to share some insights on evaluating discounted cash flow (DCF), a popular tool for determining value.

In other words, the DCF valuation model is based on an estimate of the future cash flows of the business. It is expressed in current dollars using business risk estimates and current and future money values. ²While there is much to be said and cases to be made about using other valuation methods such as price multiples in certain scenarios³, in this article he will focus on the DCF model.

We believe DCF has many advantages in determining value, including:

• They focus on the right measure of value. Ultimately, we believe that the cash flow streams generated by our business are the most appropriate measure of value. Other valuation methods often do not focus on this type of measure of value and overlook things such as the working capital requirements and capital expenditures a company needs to create value.
• Growth is important (multiples are static). This is one of the most obvious advantages of DCF, especially over price multiples. Consider two businesses, Company A and Company B. Company A makes $100 a year and Company B makes $10 a year. Using the same revenue multiple for both, Company A would be valued much higher than Company B. But suppose Company B can grow at 50% a year for his 10 years and stop growing when revenues are $384 a year. A prudent investor would not want to apply a multiple price to the end state profit level. After all, growth is not a certainty. What should I do then? Such consideration may be difficult to express in multiples. ⁴ The difficulty is partially explained by…
• Timing matters. As suggested above, DCF describes the timing of cash flows. Even if you think an investment will definitely pay out $100, it makes a difference in the value of the investment whether it pays out next year or 10 years from now. increase. Many other evaluation methods do not.
• Break down your value drivers. A good DCF is based on key business value drivers. This allows you to shape your view of overall performance by breaking it down into manageable pieces, making overall revenue more predictable. This also helps with risk management, as investors can use her DCF model to identify and quantify the key risks facing their business and invest accordingly.

Despite these (and other) advantages of DCF valuations, they are not foolproof. It is not easy for most investors, including professional investors like Mint, to estimate the cash flow of a business. is not. ⁵ This can lead to overly complex models with many variables and many calculations. That complexity makes it easy to be overconfident in estimates and aggressive in investment decisions. Additionally, being able to use more variables, such as key business value drivers, is beneficial but does not always lead to more accurate estimates.

At Mint, we don’t just use DCF to measure our business. Our robust process helps overcome potential biases and traps that DCF introduces. But we think they are effective tools in an investor’s toolkit, forcing investors to focus on value and not what Mr. Market says. .

¹ If unfamiliar, read about Mr Market in Benjamin Graham’s book The Intelligent Investor, or get a quick rundown here. Mr. Market – Wikipedia.

² This estimate is called the discount rate and, quite simply, is the rate of interest in terms of reflecting the value of deferring consumption from the present to the future and the risk that the investment may not be repaid. You can think of it as something like

³ In other words, we believe it is a good inference of relative value for mature businesses.

⁴ Not impossible, but the task becomes more difficult given that the length and profile of growth can vary from business to business. This is another reason why you’re trying to do too much with too few variables and get bogged down with multiples.

⁵ I’m going to quote Warren Buffett’s warning about the investment process and repurpose it here. Simple, but not easy.

Disclaimer: Sam Arcand Mint Asset Management LimitedThe above article is for informational purposes only and is not intended to be investment advice.
Mint Asset Management is the issuer of the Mint Asset Management Fund.Download a copy of Product Disclosure Statement for mintasset.co.nz

Mint Asset Management is an independent investment management firm based in Auckland, New Zealand. Mint Asset Management is the issuer of the Mint Asset Management Fund. Download a copy of our Product Disclosure Statement here https://mintasset.co.nz/assets/PDS-SIPO/Mint-Product-Disclosure-Statement-2020.pdf

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