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Re: DCF techniques?

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By emiller8988
January 12, 2005

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Matthew, I'll tell you what I do. First I remember this... in the stock market, anything that everybody knows is not worth knowing. C Munger once said he's never seen Buffett do a DCF ... My view of these things is best summarized by this brief exchange at the 1996 Berkshire Hathaway annual meeting: Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one." "It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close."

I think it's critical to know and understand the process of discounted cash flows. But once you know them... understand the inputs and start to realize the wide variations we get from very small changes in the inputs... they loose a lot of their shine. Furthermore, it's the inputs to the DCF analysis that make all the difference anyway. If you know a company well enough to be more accurate with the inputs than most investors... you've already left them in the dust with your level of understanding of the company anyway.

I've got 10 commandments for my analysis of a company and its equity. I think if I have an excellent handle on these items, the DCF analysis almost takes care of itself...

2- Changes in perceptions of a company and industry fundamentals are the catalyst for a stock's movement. Those changes need to be anticipated before others do.

3- The most important factor in anticipating change is to understand the competitive position of a company and its industry.

4- Qualitative factors are probably more important that quantitative.

5- Decisions must be made with limited and conflicting information. If you wait until you have all the facts... you are buying an efficiently priced equity.

6- The more complex my reasoning, the more likely it is to be wrong.

7- The best investment are always anti-consensus. If the consensus opinion is correct, outsize results cannot be obtained.

8- I must know the company's key operating indicators to accurately anticipate changes in fundamentals.

If you understand the competitive position of a company... the qualitative factors... the key operating indicators...

Think about Netflix. I saw all these glowing DCF's on the company a year or two ago... all making assumptions. I thought were nuts because they ignored a completely indefensible competitive position... what about a DCF on MRK right now? How do you factor in the lawsuit crap? Will there be legislative relief for tort reform?

One of the items I really liked about Greenwald's book was the idea that DCF analysis was the last and least accurate of a three-tiered evaluation of a company and it's equity.

The stethoscope is an interesting tool for the doctor. A medical student will spend hours upon hours learning the nuances of various heart murmurs and gallops. After a few years in practice a good doctor should be using the stethoscope only to confirm what he already suspects from a well-taken history.

Likewise the DCF... the inputs are far too easy to fudge. A conservative DCF analysis ought to do nothing more than confirm what you already know, having taken a good "history" of the company, it competitive position, its management, etc

That's how I use DCF spreadsheets


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