85 - Precisely Wrong, Roughly Right (DCFs)

Mental Models discussed in this podcast: Discount Rates Gordon Growth Model Discounted Cash Flow Calculation Please review and rate the podcast If you enjoyed this podcast and found it helpful, please consider leaving me a rating and review. Your feedback helps me to improve the podcast and grow the show's audience.  Follow me on Twitter and YouTube Twitter Handle: @TreyHenninger YouTube Channel: DIY Investing Support the Podcast on Patreon This is a podcast supported by listeners like you. If you'd like to support this podcast and help me to continue creating great investing content, please consider becoming a Patron at DIYInvesting.org/Patron. You can find out more information by listening to episode 11 of this podcast. 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.