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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: Freedom Fighter who wrote (239)	4/23/1998 8:09:00 AM
From: Reginald Middleton	Read Replies (3) \| Respond to of 1722

<You seem to be very familiar with CAPM and related subjects. I have studied two valuation books on the subject. Valuation - Mckinsey & Co Investment Valuation - Aswath Damodaran I have also purchased the spread sheet model from the former.> The Aswath Damodoran book is good from what I have read but I must admit I have not read it all (he is a local professor here at NYU, nice guy and very smart), and the McKinsey book is very informative. They give a very good motive for using the 20 yr. rate in lieu of 30 year, T bills are out of the question for they do not match a long term perspective (think of matching the perspective horizons of the company you are valuing and the risk free rate you are using as a cost base). The spreadsheet in the McKinsey book does well at reconciliation to net income, but does an awful job in its DCF analysis (if I am not mistaken it only costs 60 dollars or so - which makes it akin to share ware, I am sure they use a better version in house). <I do not like beta or any similar item as a measurement of business risk. It may be measuring some kind of risk (market) and it may even be correlated to business risk, but there are examples in actual practice where I think it is way off the mark. I make subjective judgements based on history and my view of the present and future business risks instead.> That is why beta is and should be modified (see my last post where I gave a arithmetical method of assuming business risk based on dev. of operating results, asset size, diversity from a body of related industries and subsectors). Subjectivity should never be used in the calculation of the cost of capital (your bias will produce inconsistent methods and consistency is the key to success), that is why I created stastical methods and stick to them. <The cost of equity is measured differently by different practitioners. Some use Govt. T-Bills, some use 30 Govt. Bonds, some use +3.5%, some use +5.5%. There does not seem to be a standard> As I have stated earlier, McKinsey's book offered a very plausible argument for the 20 year bond. As for the historical risk premium, my last post offered what I consider to be a very plausible reason for using the markets entire history in lieu of interjecting subjectivity and bias. By using the entire history, you will have a floating number, but it is around 5.8% right now. The entire history apporach is the closest to a standard you will get, and that is that most serious practitioners seem to use. <Some of the ideas about the capital structure also seem very hazy. The cost of capital is cheaper for bonds certainly, but as you increase debt and Return on Equity you also increase risk. There are some guidelines as to how to handle these capital structure issues, but it is also very hazy.> As you increase debt, you increase the volatility of cash flows due to the excess leverage, therefore you increase business risk indirectly. This volatility shows up in an empirical analysis of business risk (see the post where I displayed the numbers). Excess leverage also increases beta - although as you said, beta has a major flaw. The flaw in beta is that beta does not truly correlate with market return over the medium term, which is why you must seriously reconcile beta. MSFT has had a lower beta than the S&P 500 for some time now, but it has seriously out performed the S&P 500 has well. This is contradictory in the CAPM sense. I use a synthetic beta approach, the statistical business risk analysis I exhibited earlier. <The terminal or residual portion of the value is of greater importance to the ultimate calculated value than the first 5 years. I do not think it is a safe bet that most companies will be around for the time required to approximate the value the model produces. Many certainly but, I suspect not most. This can produce some very speculative and I feel inaccurate results.> The risk of a company going out of business is also covered in the business risk adjustment to the cost of capital. This is also another reason why it is so very important that longest possible period of historical equity performance be taken into account when using a risk premium. That is why the BRI goes up as the amount of cash flow volatility goes of (STD Dev), which also increases as leverage is increased. You see, it is all connected. <Small changes in the terminal growth rate assumptions, like will it be 5% or 6% or 6.5% can produce dramatically different conclusions. Let's face it noone knows these things.> No one knows anything about the future. This statement applies to a lot of topics outside of CAPM and DCF:-) <So while I agree with the model on an intellectual basis and use as much of it as I can (especially free cash calculations etc..) I believe it is flawed in practice even though it is used by most.> Most of the flaws are fixable, many are obvious if you hold the concept to a candle. My commercial grade model has nearly 400 adjustments to it and is roughly three time the complexity of the one found in the Mckinsey book, yet it is almost fully automated. Many banker's in the New York area are starting to pick up on it. As for Buffet, I am sure he is a terrific investor, but many of his followers fail to take into consideration the momentum and size of his capital, which serves to drive his returns. They also fail to take into consideration his active involvement with mgmt. which has a lot to do with success and failure (think of the terms he got on the Solomon preferred, then think of the control he had when Solomon got in trouble). Soros, whose stated returns appear to be greater than Buffet's, does not get the same reverence or respect. I wonder why...