85 - Precisely Wrong, Roughly Right (DCFs)

Mental Models discussed in this podcast:

• Discount Rates
• Gordon Growth Model
• Discounted Cash Flow Calculation

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode85

Why DCFs should not be used 

• What is a DCF?
  • An estimate of all future cash flow (dividends or earnings) and discounted back to the present.
  • When you add up these values you get the intrinsic value of a company.
• Gordon Growth Model (perpetual constant growth of a dividend - DCF)
  • P = Div (next year's) / (r-g)
  • R = discount rate (10%)
  • G = constant growth rate in perpetuity.
• Example:
  • Dividend = $1.64 (Coca-Cola)
  • Specific estimates: $27.85 (based on specific year estimates)
  • Growth rate: 3% = $23.42 (equivalent to a 7% dividend yield)
  • Growth rate: 5% = $32.80 (equivalent to a 5% dividend yield)
  • Current price: approx. $46 per share
  • Always invert.
    • Dividend yield of 3.5% or growth rate of 6.5% in perpetuity.
• Example 2: P/E ratios for growing companies.
  • I want to estimate how quickly I can reach a 10% earnings yield.
  • I want it to be less than 5 years.
    • Without compounding this means a 10% grower you can pay P/E of 15.
    • A 20% grower you can pay P/E of 20.
    • All of these imply you can sustain that growth for 5 years.
    • Why ignore compounding? It's simpler and conservative. 

Summary:

Discounted Cash Flow calculations and models provide precise estimates of intrinsic value but tend to be flawed. It is much better to improve accuracy by ignoring DCF and using a simple intrinsic value calculation like the Gordon Growth Model.