Why Investors Can't Model Optionality in a DCF

In this episode of "The Morning Show" on Motley Fool Live, recorded on Dec. 21, Fool Senior Analyst John Rotonti explains that while it's extremely difficult to model optionality in a discounted cash flow (DCF), you don't even need to. Follow along in the video below for his reasoning -- and get a great investing book tip as a bonus.

John Rotonti: Dominic Rinaldi asks -- Hi, Dominic -- "Don't DCF predictions just fluctuate so much that it's only directional because this can't take into consideration new revenue streams and products that don't exist yet?" Absolutely. You cannot model optionality in a DCF. It's very difficult to model optionality in a DCF. However, if you're using your reverse DCF, you don't have to. Then I have an ancillary thing I need to say to this, but if you're doing a reverse DCF, all you're doing is finding out what rate of free cash flow growth and how long those free cash flows have to grow a number of years to justify today's stock price. That's a much different question than trying to predict future revenue streams. Trying to come up with assumptions for revenue streams, and operating margins, and tax rate, and reinvestment, and all these other things. All you're doing with a reverse DCF is seeing what growth rate is priced into the current stock price and then asking yourself if that is reasonable. That's No. 1. No. 2, let's say you do that reverse DCF and you still find that a stock of a business that you love, the reverse DCF still says the expectations are too high. Then you take Step B, which is you do a real options pricing model. You can actually use Black-Scholes or some other options pricing mathematical formula to determine the amount of optionality priced into today's stock price. Here's a holiday gift for all of you. Michael Mauboussin and Al Rappaport, in their updated and revised Expectations Investing, they walk you through step by step as if you're a fifth-grader, as we were asked to do earlier today, the reverse DCF and the options pricing. Because for some of these companies, Dominic, you can't just rely on even the reverse DCF. You have to layer on top of that the options pricing model to determine how much optionality is priced into a stock. Then you ask yourself if that is reasonable. They spell it out for you in the book better than any other resource I've ever seen. It doesn't mean it's easy. You still have to put in a lot of work. You still have to get good at this. You have to put in the time and the practice. You have to drill it, you have to drill it, you have to drill it, you have to drill it, you have to drill it for years until you get good at it. But the tool is there to learn how to do this. But yes, traditional DCFs, I don't do them because of that. You can't model optionality. It's really hard.