Equity Research for Value Investing 2

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Finally, the problem with determining a feasible growth rate is that a DCF will simulate the growth rate to be eternal, and we know that no business can sustain an above-average growth rate in perpetuity.

Let's now move to the strengths of a DCF model as a stock valuation tool.

George Edward Pelham Box, a Professor of Statistics at the University of Wisconsin, and a pioneer in the areas of quality control and experimental models of Bayesian inference famously remarked:

All models are wrong, some are useful.

I would argue that the DCF model can provide a useful stock valuation estimate as part of fundamental stock research if the user follows the following principles:

1. Invest in companies that have a sustainable competitive advantage. Stock investing should be though of as ownership interests in these companies.

2. As Buffett alluded to in his 1994 letter, certainty in the business is essential. I therefore look at different measures of stability in revenues, earnings, book value, and free cash flow as part of my equity research.

3. Your stock research should include through due diligence in analyzing companies financials (income statement, balance sheet, cash flow statement, efficiency ratios, and profitability ratios over at least a 10-year period of time.

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4. Before using a DCF stock valuation model or a PE and EPS estimation method for valuation, kick the tires by using a valuation model that requires no assumption of future growth. Jae Jun at http://www.oldschoolvalue.com has some very nice articles and examples on this topic (reverse DCF and EPV). I like to use the Earning's Power Value (EPV) model (described below).

5. Look at simple relative valuation metrics such as P/E, EV/EBITA, PEPG, P/B etc.

6. Employ conservative assumptions of growth and a discount rate between 8-13%.

7. A healthy dose of intellectual honesty is needed so as not to modify the key growth and discount rate assumptions to arrive at a pre-conceived intrinsic value.

8. Always use a Margin of Safety!

As mentioned, I am a big fan of Professor Bruce Greenwald's Earnings Power Value calculation. Earnings Power Value (EPV) is an estimate of stock valuation that puts a value of a company from its current operations using normalized earnings. This methodology assumes no future growth and that existing earnings are sustainable. Unlike discounted cash flow models, EPV eliminates the need to predict future growth rates and therefore allows for more confidence in the output. It is a valuable tool as part of thorough equity research.

The formula: EPV= Normalized Earning's x 1/WACC.
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