Silicon Investor (SI) -- The First Internet Community

STOCKTALK

We've detected that you're using an ad content blocking browser plug-in or feature. Ads provide a critical source of revenue to the continued operation of Silicon Investor. We ask that you disable ad blocking while on Silicon Investor in the best interests of our community. If you are not using an ad blocker but are still receiving this message, make sure your browser's tracking protection is set to the 'standard' level.

Strategies & Market Trends : Gorilla and King Portfolio Candidates -- Ignore unavailable to you. Want to Upgrade?

To: Seeker of Truth who wrote (39407)	2/16/2001 6:22:27 PM
From: EnricoPalazzo	Read Replies (1) \| Respond to of 54805

<MATH> What I don't understand is how you derived the formula for the residual value. R = FreeCashFlow(next year)/(k - g). R is the residual value. k is our discount rate. In percent it's k%, in decimals it's 0.01 times k. g is the growth rate. Without looking back at Pirah's post, I don't know exactly which years he's talking about for the residual value, but here's how you'd calculate the present value of a cash stream that will give you FCF in one year, FCF * (1+g) the next year, and so on, with a discount rate of (1+k). For consistency, I'll use the same variables as in your quote. R = Sum(from n = 0 to infinity) of FCF * (1+g)^n / (1+k)^(n+1) R = FCF/(1+k) + Sum(from n = 1 to infinity) of FCF * (1+g)^n / (1+k)^(n+1) R = FCF/(1+k) + Sum(from n = 0 to infinity) of FCF * (1+g)^(n+1) / (1+k)^(n+2) R = FCF/(1+k) + ((1+g)/(1+k))* Sum(from n = 0 to infinity) of FCF * (1+g)^n / (1+k)^(n+1) R = FCF/(1+k) + ((1+g)/(1+k)) * R R * (1 - (1+g)/(1+k)) = FCF/(1+k) R * ((1+k)/(1+k) - (1+g)/(1+k)) = FCF/(1+k) R * ((k-g)/(1+k)) = FCF/(1+k) R = FCF/(k-g) </MATH> The general idea is that a dollar in one year is worth $1/(1+k) today. So if you can guarantee that the cash stream will grow faster than its value depreciates, that is indeed worth an infinite amount of money (supposedly). In my opinion, this is one problem with DCF theory, but I can't really wrap my brain around it. In the very long run, few companies seem able to grow cash flow faster than the discount rate (KO may be an exception, which may be why Buffett says "hold forever"). Incidentally, I think that DCF is a really interesting and important way to value certain types of stocks. IMO, though, it's just not that useful to us since long-run growth rates of this class of tech stocks are so hard to predict. I doubt that many DCFs of EMC in 1990 said that its DCF was 1,000 times greater than its price, although that turned out to be roughly the case (OK, off by (1+k)^10). Also, real options theory may be more useful for tech stocks, but it's really hard to do (I think--I don't actually know how to do it), and maybe not worth the effort. I think The Fool used to apply it to Amazon, which hasn't really helped the theory's credibility as a valuation tool... ardethan@caveatemptor.net

To: Seeker of Truth who wrote (39407)	2/16/2001 6:40:38 PM
From: Pirah Naman	Read Replies (1) \| Respond to of 54805

Malcolm: I decided to junk my efforts and follow your scheme. May I suggest that you don't do either just yet? Rather, see how the tools I use meet your needs and then decide? What I don't understand is how you derived the formula for the residual value. I didn't derive it. It comes from a more complicated summation equation which I couldn't remember to save my life. I think that a better explanation than I could hope to give is in The Witch Doctor of Wall Street by R. Parks. (It's a good book in general.) I've seen other explanations, but that is the one I can remember to reference. What if k = g? This usually suggests that you have set your k too low. (You have found, already, one of the key points to nitpick here - the model is sensitive to slight changes in input here.) There are many ways to choose k. One is to use the long bond yield, or the long bond yield plus an equity premium. Some people calculate an equity premium unique to each company, using a formula which incorporates weighted average cost of capital and share price volatility (beta). I prefer to use the simpler approach; there is so much error in guessing at the future, that to me a more complex calculation does not seem to add value proportional to the invested time. Also, for g during that residual period, I suggest using the average growth rate in earnings of the S&P500 over an extended period. Various books show it in the range of 5-6% depending on period chosen; I think I once calculated it at 6.4% over the past 25 years (ending in late 90s). - Pirah