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Strategies & Market Trends : Value Investing -- Ignore unavailable to you. Want to Upgrade?

To: Jurgis Bekepuris who wrote (42983)	6/11/2011 2:51:32 PM
From: E_K_S	Read Replies (1) \| Respond to of 78746

Hi Jurgis - You are correct the author might be a little optimistic in his estimates. I believe that the simple DCF valuation model is flawed and generally will not work well in the current economic environment. That is because we will have unusually wild swings in both the actual and perceived interest rate(s) due to the Fed's aggressive monetary policies (especially w/ QE2 ) and the unprecedented large U.S. debt and looming financial crises. The "discount rate" which is typically pegged at the ten year treasury rate is usually used in these present value calculations. Today it is historically low around 3%. (When in history do you recall the Feds Funds rate at zero.). I think Warren Buffet uses a historical rate of 6% and anything lower than that he is generally bullish on the economy. Therefore, with real rates so low, everybody is generally very bullish for the future (unless "deflation" expectations make them see differently). General market psychology affects future stock prices which the discounted cash flow analysis totally misses. Future expectations play a huge role is how capital is deployed. As long as rates are no more than a 2% standard deviation from the historical norm, everything is cool. The cost of capital is known and generally fixed. Projects can be scheduled out five years or more with some certainty. However I see the next five years as one where it is not going to be normal. Rates will be outside the historical norms BOTH very low & very high. It is going to be a very difficult environment to operate in. Expectations (Inflation & Deflation) are going to be all over the board. In fact, I bet that nominal interest rates deviate outside the historical average. These wild swings will cause BOTH PE expansion first and then PE contraction. PE expansion will occur first which will over value equities and then as we approach the out liner threshold for inflation (w/ very high inflation expectations) PE contraction will occur which will significantly under value equities. When you fall into these out liner regions, it present a roller coaster ride for the long term investor. Nothing has fundamentally changed in the company's valuation other than the actual and perceived "cost of capital" (due to inflation/deflation expectations). Management's expectations for inflation (and/or deflation) will impact their decision on when and how much to expand and/or invest. This decision will impact on the company's growth. So maybe the one most important investment criteria for the successful company will be it's management and how well they can temper their expectations. Unfortunately, you can't really quantify what the cost of capital will be five or more years out and how management will act (or react) just using a simple DCF analysis. It's going to be an interesting ride for all investors. Inflation & P/E Multiple Contraction/Expansion Posted on February 10, 2011 by Babak tradersnarrative.wordpress.com EKS