The Forsaken 50%!

What if I told you that 99% of investors (professional and individuals alike) were missing out on a large chunk of the analysis in measuring the value of an investment? How can that be given how quickly news and data flow around these days? What am I smoking?

Well, that is essentially what happens when viewing an investment as a series of discounted cash flows.

As I have mentioned in previous posts, the value of any security or investment is the Net Present Value (NPV) of all future cashflows from the instrument into peretuity, discounted at an appropriate discount rate. While the definition makes a lot of sense, the actual application is much more difficult. What growth rate do we use? What discount rate do we use? We can't use infinity in the number of cash flow periods for the calculation you know. How are we going to do it?

Well, typically, the discounted cash flow (DCF) analysis employed by Wall Street and others (who have the confidence to actually project these numbers--which I have obvious reservations about given that reality is not that simple) use a 10 year model. They tend to take the current EPS or cashflow and put a growth factor of say 10% per year over the next 9 years. For the 10th year they apply a multiple (or a price earnings ratio) of that 10th period cashflow to estimate the "terminal value". Here's an example:


Earnings in year 1 is $100 growing at 7% per annum with a terminal earnings multiple of 15 times earnings (pretty standardised assumptions).

Yr1 100.00
Yr2 107.00
Yr3 114.49
Yr4 122.50
Yr5 131.08
Yr6 140.26
Yr7 150.07
Yr8 160.58
Yr9 171.82
Terminal Value: 2757.69 (171.82*1.07 *15)
Terminal Value Discounted @10%: $1,063.21
Total Value: $3955.49
Total Value Discounted @ 10%: $2,170.24

Now notice how much the discounted value is accounted for by the terminal value....a whopping 49%! ($1,063 / $2,170)

In other words, almost 50% of the "value" of this security is based on what occurs AFTER a 10 year period. Again, 50% of the value is based on what occurs after a 10 year period.

So, why does Wall Street and CNBC and others get mesmerized by quarterly earnings, when the results only really account for a fraction of the actual value of a real business? Beats me, but it sure makes my job as a value investor that much easier. For me this speaks volumes about thinking about investing for the long-term.