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

To: Mike Buckley who wrote (43598)	6/17/2001 7:40:13 PM
From: Pirah Naman	Read Replies (2) \| Respond to of 54805

John, Mike: Before we all start taking each other seriously, I'd like to try to lay out some common ground and see if we can't find peace and harmony. We are, all three of us, in agreement that narrowing the field of possible investment opportunities takes priority over valuation (or pricing) efforts. None of us would argue against the assessment of competitive advantage, the sustainability of the business, and the attractiveness of the annual report cover before having fun with numbers. We are, all three of us, in agreement that gazing into the future is fraught with error and can render the best analysis, via any method, as helpless. Here is where you two are having a misunderstanding. Mike, you said that "I can't begin to explain why the math validates one model more than the other." That is what John tried to explain. John, you added in ramifications before your audience had a firm handle on the rest. That can be confusing to somebody not as familiar with the material. - Pirah, the fearless (stupid) peacemaker?

To: Mike Buckley who wrote (43598)	6/17/2001 7:58:40 PM
From: Thomas Mercer-Hursh	Respond to of 54805

I've run DCF models in the past (not recently.) I've found that regardless of the model, the biggest problem is in understanding the probablities about the future of the company in question. To me, the really significant difference between a meaningful model and a simple DCF spreadsheet, which is a sort of barebones model, is that the numbers derive from something other than historical numbers and various guesses about a future pattern. This is not to say that there isn't still a good measure of guessing and assumptions in even the most detailed models, but a good model will bring one much closer to the underlying business issues where the guesses can be more intelligent. One of the more obvious examples of this is seen in projections of growth rates, perhaps not in the current market, but during some of the exhuberent times in the recent past. Take the growth rates that some high tech companies have achieved and project them forward far enough and soon the company is larger than the total economy. Obviously that is nonsense, but the interesting question comes in looking at the factors that will limit that growth. For example, at some point well before the point of complete nonsense, such a projection will first exceed the size of the market the company's current product addresses, even if that market itself is projected to grow. Well, that too is nonsense. So, obviously there will be some pattern of diminishing returns in saturating the current target and some need and potential to address other markets in order to keep growing. Well, what does this look like? Is the company at the stage of having 5% of the near term projected total market so that it could continue to grow extremely fast for a few years or is it at the point of already having 50% so that the inflection is likely to be coming soon? To be sure, one still ends up making guesses in coming up with projected patterns to address these questions, but the guesses are fairly closely tied to market and product realities and other people can examine and verify or disagee with those assumptions in a fairly meaningful way, which one can't with overall summary figures and ratios. Some years back I was involved as a technical advisor to a company, in which context I was made privy to a five year revenue projection which the company had done internally. This revenue projection consisted of a fairly optimistic and basically linear projection of increasing sales of their core product line plus and increasingly large component from new products which was actuallly a majority of the total by the end of the five years. The problem was that the core product was already going through something of a rough transition of versions at that point in which there was a couple of year period of strained sales from people not moving forward with the latest version as they had previously. So, any projection about sales of the core product should have included addressing this issue and should moreover have recognized that in the broader market the company was experiencing some loss of favor in relationship to the competition. I.e., either the product had to do something to become more competitive and to bring along the installed base or it was likely to have lesser, not increasing sales. Plus, they had just made their first acquistion of new technology related to the new product portion of the projected revenue and its current revenue was little more than a flyspeck on the overall company revenue and there was no reason to expect exceptionally dramatic growth from that product, especially beyond some obvious market limits. So, what was all this projected new product revenue? Complete hot air and hope.

To: Mike Buckley who wrote (43598)	6/17/2001 11:08:58 PM
From: Stock Farmer	Read Replies (1) \| Respond to of 54805

Hi Mike You are perceptive. My sense of humor is very dry, sometimes gritty. But it is intended as humor. I should possibly use more emoticons. Let's go line by line. >>As I've read all the posts, I've come to the conclusion that the differences of opinion have a lot more to do with the definition of "fiction" rather than anything having to do with the math. My impression was that the issue of fiction as a basis for a PEG ratio, or lack of it, was what the discussion was all about, not which of the three models (DCF, PE, or PEG) is the best one to use." Yes. I think here we agree. All three are merely models. All models are wrong, some are merely useful [Einstien]. I was perhaps skipping steps by evaluating comparative usefulness at the same time as discussing the models. >>I also don't believe my inability to understand the theory of the math should be construed with an inability to run a DCF. I can (and have) run PEs, PEGs, and DCFs, but I can't begin to explain why the math validates one model more than the other.<< No issue with this. Many people enjoy sausage but haven't got a clue how to make it. And shouldn't ever find out IMHO <g>. >>As I mentioned, I've run DCF models in the past (not recently.) I've found that regardless of the model, the biggest problem is in understanding the probablities about the future of the company in question. << This part I don't know I understand: "understanding the probabilities about the future of the company"... It's not so much as probabilities as it is just guessing the cash flow. So many people say "this will be a kazillion dollar market in ten years, and this Gorilla will be taking 80% of it..." So in column 5 put 80% of a kazillion as sales and take it from there. I don't see how one is more difficult than the other. I can't believe people would pay $50 for something earning less than a buck if they didn't have at least some faint inkling that the company will return their money. All DCF analysis is asking for is that these faint inklings are captured on paper. I think the hard part is when the results cause an involuntary violation of faith "I have to own XYZ, it's a Gorilla" can collide with "you'll never get $xx a share back in anything less than a century". I use this collision to test my faith. Usually the money wins. I'd rather miss out on a profit than capture a loss. But that is my style. >>However, it's not simple to arrive at a DCF that is especially meaningful just as it's not simple to arrive at a PEG that is especially meaningful. That's why it's more art than science. << Actually here we disagree but only in part. I agree that arriving at a DCF that is accurate is difficult, and requires insight into how the company works. Which requires among other things that someone be able to read and disassemble the company's financial reports. Which a surprising number of people fail to admit they can not do. I still don't know enough to do an excellent job and I am thankful for the many patient experts who have gently or rudely corrected my posts and/or advised my by PM. That's the part we agree on. We also agree that use of PEG is an art. Where we seem to disagree is the usefulness of this art. <Font=sarcasm, bold> Like witchcraft is an art. So what. You take E (a number prone to financial engineering) and multiply it by G (one good guess). And get another number. I can prove to my satisfaction that this third number is unrelated to the economic value of the firm. Which seems to me to be a less than suitable tool to use for establishing the value of a slice of the firm. Does this not make the least bit of sense? Sure, there are still avid practitioners of the art, but none can explain the reason why E * G is related to the economic value of the firm... indeed they all seem to run from this question like vampires from the light. Please, some lurker, prove me wrong? But until then, it smacks to me of the proverbial "dangerous thing" based on "little knowledge". Sorry if my big clown shoes are stepping uncerimoniously on sacred ground but that's the way I see it. >>If running a DCF that accurately predicts the cash flows and thus projects a fair value for owning part of a company was really so simple, we wouldn't have had all the VC firms and other so-called professional investors using DCFs paying prices for companies that are unsupported by what those cash flows ultimately prove to be. In fact, some of those companies don't have a cash flow on this very weekend.<< Woah... you've gone too far here. Firstly, the VC game is not about discounted cash flows. It's about harnessing the power of smart money to vacuum dumb money off the street. At least in the new economy. Call me a cynic, but I've dealt directly in this zone. Secondly, when your VC friends get in, they are in at the proverbial ground floor, with preference rights that make a deal with the devil look charitable. They are looking for economic models robust against a discount rate in three digits! This is the 20:1 payback zone with a 90% infant mortality rate. Still makes them all two-baggers on average. Not a bad business. Next are the professional money men. Who in their right mind is going to stand by and miss out on the gravy train? Wall street invented the most efficient mechanism of vacuuming money from pockets that people have ever seen. Sure, a lot of folks hold new economy stocks at rediculous prices now... but if you check it out, there is a lot of more profit than loss for those who got in big and got in early. As for the public investors, yes, they took it in the teeth. But this is always the way. It is the whole point of the stock market. Those Ferrari cars that money managers drive around don't appear presto like magic. Before the new-economy had every idiot on the planet whipped into an "I gotta get those IPO shares" frenzy, DCF mattered and it used to take 2 years of solid results before a company would think of floating an IPO. That time is coming again. I've noticed a dramatic reduction in rate of froth IPOs recently. Kraft. Hmmm... Seems to me that business has been running for a while. Contrast with Loudcloud. No contest. Compare DCF... hmmm... even the best of Madison Ave and the combined might of the moguls of the new economy failed to pull the wool down far enough. No, please don't try to go there with this cynic <ng>. Fundamental economics matter IMHO. If one pays more for a slice than the fractional value that will be generated, one is holding an unrealized loss. Perhaps like "hot potato" one can sell it to someone else for a greater unrealized loss... and so on. This works... provided that you don't swap your avoided unrealized loss for someone else's avoided unrealized loss... and until someone 'realizes' what they are holding. You can pray it isn't you! Or you can take some few small steps to protect yourself. Like paying attention to the truth that the fundamental economics of the firm do matter in the long term. Yes, the last five years have been characterized by a convenient sweeping of this truth under the carpet with a broom of greed and an abundance of greater fools. But this recent "correction" is helping to set things to right. Those folks who have the firmest grasp on fundamental economics will emerge most successfully from a LTBH perspective. Pay less than the value being generated and you can sleep soundly with confidence that you have not just purchased a loss. That leaves capital preservation and profit. Both are good. From a trading perspective, it's a whole different matter, and don't even try to convince me that anything but momentum matters. DCF, PE or PEG... all out the window. Just my opinion of course. Sorry for the rant, but it's a hot button of mine. >>Just my way of looking at investing. There are lots of ways to invest profitably.<< Here again at least we can close on common ground. My priorities are to maximize the probability that the person who profits from my investment is me! John.