Rule Breaker Mailbag: Does the Fool Use Discounted Cash Flow to Judge Stocks?

In this segment from the Rule Breaker Investing podcast, David Gardner dips into the mailbag and finds a question from a new Fool whose university education included a fair bit on methodologies for valuing stocks.

The problem he finds is that while there's an enormous amount of data available about companies' past performance, he's not so impressed with the idea of plugging it into those formulas he learned to make predictions about the future. Does the Fool team use "comparable analysis"? His response says less about which tools are best used to measure what you ought to be willing to pay for a stock and more about the fact that predictions using those mathematical models are only getting harder as the world changes faster.

A full transcript follows the video.

This video was recorded on Aug. 30, 2017.

David Gardner: Mailbag Item No. 6. Now this one is the classic "but what about valuation" question, and it comes to us in this form from Eric, who is a 20-year-old investor who studies finance at Wilfrid Laurier University in Waterloo, Canada. "I'm a reasonably new listener," Eric writes. "I haven't yet made my way through all the podcasts, so this may have been answered. If so, I apologize.

"But in university our professors stress the importance of financial modeling for stock analysis, comparable analysis, discounted cash flows, etc. For certain companies with a predictable business, discounted cash flow analysis (DCFs) can make sense; but for the best stocks that are likely to outperform the market, predicting what free cash flow will be in the year 2025 is a fool's errand," Eric writes.

"I also hate all the assumptions that are made. For example, the discount rate, used in DCFs," Eric writes, "is almost always generated from the capital asset pricing model, the CAPM, and that assumes that beta equals risk. If a stock has fallen 50% to the market's 25%, the beta of that stock will be two and it will result in a risky business and a high discount rate. But if the decline is unwarranted," Eric says, "well, hasn't that stock become less risky?" It goes on a little bit more from there but "Do DCFs matter? Does the Fool team use comparable analysis," Eric asks.

So this timeless question about what do we do with valuation. Here's my own cut at it here in August of 2017. I think it's really good to learn what you're learning, Eric. Not all of us who invest, even those who invest successfully, can even do a discounted cash flow analysis or has been taught or trained in capital asset pricing and I include myself among that group.

I am basically an English major and I was taught the stock market as a kid by my dad. I've learned a lot since the age of 18 when I took over my account in full and made all the decisions ever since. Now here I am 51 years old; but I don't have some of the training that you're getting as an undergrad right now.

I think it's great to know, and the analogy I often use is with the game of bridge, the card game of bridge. I realize not as many people play it today as when I was taught bridge as a young kid, but you need to learn how the bidding system of the game of bridge works.

There are some codes. Some standards. When I open three hearts, I'm saying something very specific, and if you're a bridge player you know, and if you're not we won't bother because this podcast is already going to be too long, but just trust me. You need to learn the basics of how to bid in order to play bridge.

And yet, what separates the great bridge players from the ho-hum bridge players are the people who know that everyone else is going to bid three hearts; but in this situation, this person is going to go against the conventional wisdom. Is going to drop the basic rules of the game that everyone's been taught. Is going to break the rules, do it differently and, if he or she is right, is going to win big. Is going to outperform all the other players playing that same bridgeboard in that situation. That same hand of bridge.

So this is how I think about valuation work. I think it's really great background and all of us should have at least some of it. You should know what a P/E ratio is. You know when to use P/S instead of P/E. And yes, if you have this kind of numerical interest and are good at spreadsheets, you should conduct your own DCF if you like.

All that said, Eric, as you well know, the premise of discounted cash flow analysis is that you can guess what the cash flows will be of something 10 years from now, so that you can therefore project back to today what you'd be willing to pay for those cash flows assuming that they were steady and stable, and that you were successful at holding your thumb up ... licking it first ... and holding it up high in the air to see which way the wind would blow and you called it. You knew the weather.

In my experience, the world is increasingly fast changing and dynamic. And especially the kinds of companies that you're talking about -- and that I speak about every week on Rule Breaker Investing -- these kinds of companies are not at all well suited to discounted cash flow analysis.

[We found] Facebook in its heyday. We did pretty well when it came public in 2012. We're now showing about a seven-bagger for our initial recommendation of that stock. Part of the reason [Facebook has] done so well in five years, it's up seven times in five years, is because it beat everybody's predictions in terms of how much it might grow. I don't think people were thinking with their discounted cash flow analysis 10 years ago that Facebook would be in front of two billion people today.

So I think it's great to know. To have that discipline. To be able to use the tool. But I don't think you should use it to drive most of your decision-making, especially in our realm of Rule Breaker Investing.

After all, part of the nature of breaking the rules is that the valuation rules that are set up by the world and well taught, especially in academia, are the very rules we're breaking, often, to pick a stock like Facebook. Or like Priceline back in 2004. Or a stock more recently like The Trade Desk or MercadoLibre. These are stocks that pretty much break the rules of valuation. If you use those rules you'll never buy these stocks. You'll never, in my experience, buy some of the best companies in the world. So there's my answer there. Thank you, Eric.