>>>>The discount rate used should relfect the individual entities cost of capital. That is the interest rate on debt (minus the tax shield), plus the cost of equity (the historical equity risk plus the companies indivudual beta), plus the business risk adjustment accorded to the use of debt and the cost reduction accorded by the use of said debt, plus the current long bond rate as of the date of calcualtion.>>>>
<I understand the first two components of your formula, but not the last three. Also, why not use a discount rate that resembles a yield curve, rather than a constant one through the whole life of a project?>
The more debt one uses, the greater the variability one assumes towards futrure cash flows due to the added risk ofthe additional debt service (risk = deviation from expected return). so although debt reduces the overall cost of capital through legislative tax sheilds, it increases the equity costs on a non-linear basis by increasing the risk of default. When one performs a valuation, one uses todays cost of capital for the company to discount future cash flows (that is you the investor's oppurtunity cost for investing in that company given a certain risk level = the discounting rate). When calculating the actual performance on a year to year basis in order to come up with those cash flows, one can vary the cost of capital in relation to your expectations (mgmt.and corporate insiders usually know what to expect, ex. I doubt that long rates are going to go down significantly since we are slowly coming out of a recession and they were at historic lows, but we plan to reduce our working capital facility and long term debt signicantly over the next four years which sould alter our WACC). But when it is all and done, you are buying a company with today's money not tomorrow's, therefore you use the oppurtunity cost as of the date of valuation to discount back to the present value.
<Do you find your valuation models to be more successful when applied to stable, mature industries, as opposed to high-risk, fluid areas? For instance, one can probably predict Gilette's or Coca Cola's cash flows out three to five years far better than one can predict Netscape's or, IMO, Microsoft's. Do you think this theory leads to systemic underpricing of technology stocks (or for that matter small stocks) which leads to the historical difference in returns and increased volatitlity?>
The volatility of a comapny is reflected in its cost of capital which increases its hurdle rate to profit over and above its cost of capital. To compensate for errors in assumption, you use a scenario/sensitivity analysis. This effectivly hedges you against under/overestimating cash lfow for any one given scenario. As I stated before, my model outputs 27 different possiblities, given a change in the cost of capital, growth rate, compeition, buisiness risk, variable or fixed costs, etc.
<Using a 20% discount rate, if I am 10% off on the t(2) cash flow estimate, I am still about 7% off on today's valuation. When dealing with growing companies, a 10% error (in EPS estimates) is not at all unusual; in fact, estimating within 10% is probably unusual. A 100% error four years off is still a 48% error in current dollars (at 20%).>
The quarterly EPS estimate has very, very little to do with a company's overall value. The fact that an analyst correctly called within a +/-5% margin next quarters 20% decrease in MSFT's EPS has an (illiustrative example -don't quote my numbers) effect of +/-1% effect on the value of MSFT as a long term investment. The primary effect large swings of cash have on the actual value of an asset is that it increases the risk of an asset (risk = the deviation from expected return), therefore increasing the desired retrun to justify for that risk. The general public is under the assunption that quarterly, semi-annual, or even annual estimates of cash/earnings determine the value of a stock. this is simply not true. When discounting for value over a 3, 5, or ten year period, notice the contribution that each quarter makes to the overall value, very little. It is the expected cash flows over a period of time, similar to an annuity which matters.
You will be thrown much farther astray attempting to value a company using quarterly estimates than you will be using a three to five year discounting method even if you are significantly in error in your long term assumpotions (provided you perform requisite sensitivity analysis.
This has been put to the real world test with one of the most volatile, immature, fastest growing comapnies in the world. If you follow the MSFT vs. NSCP column, you will notice that I am always at odds with the majority of threads patrons (direct contracvention actually, not as professional as this thread :-), Virtually all of them use earnings and quarterly EPS estimates to value NSCP and MSFT, while I used intermediate and long term DCF. although i played the ultimate contrarian, it appeard as if I had a crystal ball when calling NSCP's rise and fall and MSFT's constant meteoric rise in the fase of general opinion. So you see, it does work in the real world. George Soros and Warren Buffet are also true beleivers in economic value.
< I guess it comes down to the original question: (1)Can we project cash flows with reasonable certainty (or with significantly better hopes than with EPS)? If the answer to that question is yes, we can rationally value an investment (given the use of sensitivity analysis). If the forecast is muddy, then we have problems>
Muddy forecasts will give you more than just problems :-), but it is still more reliable than relying on short term EPS to value an ongoing business entity. Quarterly EPS valuation are appropriate if one were valuaing a company that would be liquidated any day now. But for an ongoing concern, they come close to being worthless.
Remember what I said about sell side analsysts and their true callings. I don;t here the buyside guys quoting quarterly EPS. |
