There is something inherently stupid about forecasting cash flows and discounting them.
1. It is OK to forecast for 2 years, may be 3 years - but beyond that one is just mumbo-jumboing.
2. The bulk of a firm's 'value' arises from the terminal value. And what is terminal value: growth beyond the last forecast discounted by the difference between a discount rate / cost of capital and a growth rate.
How arbitrary can you get!!!
3. The discount rate can be the cost of capital; a part of which is the cost of equity.
Now, estimating a cost of equity is hilarious!!
How can a stock's returns regressed against a benchmark over the past x time period serve any use to the future trend?
I understand the concept of risk premium - cool! But Beta... puh-leez
One useful and quite sensible (intuitively, at least) approach is to take the earnings yield as a reasonable estimate of the cost of equity.
Stock trading at 16 Fwd P/E. So I say: If the company makes these same earnings over the next 16 years, it will equal my investment. Of course, we are mitigating growth, inflation and all that jazz. But let's think out of the box and assume that this blog belongs to some finance hot shot. Would you pay more consideration to the above rationale? Of course!
So anyhu... I go on to say.... let us reduce the divisor in the earnings yield multiple. Let's make it 12 - for discussion's sake ( which is also how many years it will take to recoup the original investment if the growth of profit is assumed to be 7%)
According to this, I say: " Notionally, I will make up for my investment in 12 years"
Of course, this is flawed - but according to me makes much more sense than a stupid Beta.
And I tell you why this is flawed.
The investment of the investor is making money in terms of dividends, capital appreciation and all the abracadabra that you can do with shares. So, in 12 years, when he makes his original investment ... the stock market will have adjusted for further growth.
4. Enough of my nonsense, going on... Value is assigned to the company based on its cash flows, irrespective of its, let's say, TEV. Why?
5. My judgment - People like using cash flows because they like saying " CAPM " ; "WACC" , "Discounting factor" , "Terminal Value".
I believe, that most people will not know these terms, apart from the people who use these terms.
So what does this accomplish?
It is a great sales strategy... don't you think so?
I believe that people are inherently stupid.
We like to create reason and order.
We like to assign a value to an entity.
And then believe in that methodology.
Which is why I like Graham and Dodd's approach.
We do not know what the value of the firm is... but it is somewhere between x and y... x < y
As long as there is a "margin of safety" let me buy in.
People have forgotten, that being a shareholder is being a part owner.
The main reason for 'issuing equity' is to raise what can be called Tier 1 or a permanent source of capital.
If you were to start a business would you be discounting cash flows and doing complex calculations?
You would say - My FD or CD earns this much. My salary is this much. Leaving aside the sheer pleasure or thrill of starting my own venture - I want to earn more than I currently do.
To hell with projections and discounting.
Is the business viable, sustainable and expandable?
Qualitative Finance baby!!
Hope nobody steals my idea and wins a nobel prize without acknowledging the sheer genius that is this author.
Imagine - if I had put in some formulae and made this a pdf and published it in some crummy journal. Would your perspective be different?