Business/Finance

Why you should always build a DCF model

Within the investing community there is a lot of hate for DCF models. Many say there are too many inputs – leaving the investor an output that is unpredictable and inherently false. Others say there is too much uncertainly embedded into a model that they are, basically, a waste of time. Finally, and this is my opinion, people are lazy and resort to a simpler method of analyzing the future value of an asset such as a multiple expansion approach.

While I wholly agree that your model is likely to be wrong 99% of the time, I believe that DCF models are a valuable tool for a research analyst. And let me take a minute to be honest. When I first started as an amateur investor, I completely ignored DCF models – resorting to a much simpler valuation approach such as multiple expansion or relative valuation. However, as I have progressed as a researcher, I now use a DCF approach for any asset that I am valuing.

So, what is so good about a DCF model? Well first they make you think like a businessman. DCF models are complex and make you think outside of the typical relative multiple expansion approach; example, “Oh Apple is trading at 10x EV/EBIT and Google is trading at 15x EV/EBIT, so that means Apple has 50% upside based on a relative expansion to Google’s 15x”.

Using a relative multiple expansion is an amateur or purely lazy way to defend the valuation of an asset you are analyzing. A DCF model on the other hand is not only more professional but makes for a better valuation case – and allows the researcher to think outside of the box.

For an example, when you are building a DCF model a few inputs into the DCF are capex, depreciation and working capital. Blindly putting random numbers into the three former inputs is the basis of garbage in, garbage out. To not allow the garbage in, garbage out mindset to take hold, you need to intuitively think like a businessman on what the specific asset you are analyzing will need going forward in terms of capex, depreciation and working capital.

It’s tough to do. If you are analyzing a cement company for example, how will you know what capex rate they will have for the next year, or even 5 years out? How are you going to know if they are planning to ramp up on a big project for future growth? How will you know what your inputs will be?

To know these inputs, you are forced to think like you are the owner of that specific asset that you are analyzing. If you were the man in charge of the cement company, how much would you spend in capex per year? How would you measure D&A after a $25 million capex spend? How much working capital will you need per every $100 million in revenues? I’m not sure of those answers. But if I were to buy shares in a cement company I would want to have some well thought out, well researched answer to those questions. There is no way I would dump 10% of my wealth in a company if I didn’t know an educated guess to those answers.

Even better, when you are building a DCF model and do not know how much an asset will need in capex per year, this directs the course of your call with management in a more quantitative approach – building a DCF model forces you to ask the right questions!

I think a lot of investors don’t ask the right questions on a management call. It’s tricky knowing what to ask in a 30 minute to 1-hour call. I have found the best way to maximize your time and managements time is to know the right questions to ask. Building a DCF model will help with preparing these questions. If you are modeling a lemon farm and not sure what the cost to plant one acre is, ask management.

Finally building a DCF model is more professional and allows you to not rely on amateur valuation methods such as relative valuation and multiple expansion. The irony of using multiples is simple. Multiples are a simplified version of a DCF – they are everything that is in a DCF but put into a simple multiple for lazy investors. The only way to properly value a business is through its future cash flows discounted at certain rate. Using a relative approach doesn’t allow deep thinking into cash flows and disregards all fundamental drivers of a business. And what’s worse, multiple valuation is used by the majority of investors to value a business. Maybe this is why the majority of investors have average returns?

If you are currently not using a DCF approach to your valuation process, I highly suggest you change your method of valuation. A DCF allows you to think like a businessman a DCF forces you to think deeply into the economic drivers of a business’s cash flow, and a DCF is much more professional than a relative or multiple expansion approach. DCF’s are tricky and your model will not be accurate. However, building a DCF model for every asset you analyze will improve your valuation skills and take you to the next level of professionalism in investing.

 

 

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