The Dangers Of Blue-Sky Thinking

Many investors I know reject the use of DCFs as a tool to value companies. The refrain I hear most often is “Well, a DCF is only as good as your assumptions – it’s too easy to manipulate the price target.” This is a truism, but that doesn’t make DCF a pointless exercise. It just means you need to spend time understanding whether the assumptions are reasonable ones.  Unfortunately the reason that many investors dismiss DCF methodology has more to do with laziness than anything else

In the wrong hands of course, a DCF can be a dangerous weapon. This is why you need to exercise caution, particularly when a DCF is used to determine a price target that isn’t justified on any other metrics. As a rule of thumb, where the current year P/E is over 20 you should maintain a higher level of skepticism.

Of all the assumptions in a DCF, the revenue growth is what I spend the most time looking at. In my experience, this is the input that is most often manipulated to create a desired valuation (sometimes called reverse-engineering). Sure, other inputs like margins, tax rate and discount rate can be easily manipulated – it’s just that they’re more obvious to spot. When an analyst really wants to justify a crazy-high valuation, revenue growth is the go-to metric. My greatest losses as an investor have come from investing in companies that failed to deliver on the expected high growth.

Albert Einstein called compounding the “Eighth wonder of the world”.  He was talking about the compounding of interest – a powerful wealth generator for investors. Applied to future forecasts of revenue however, it can be an insidious tool. The trick played on investors is to make something entirely unreasonable sound completely reasonable. There are various methods that an experienced analyst will employ here:

1. Take the five year history of revenue growth and extrapolate for the next 10.

The key problem here is that past growth achieved is rarely a good indicator of future growth. A company that started out with sales of $500m that was growing at 15% p.a. would reach $1bn in sales after five years. If the same 15% growth rate is maintained for the next ten years, the company is forecast to achieve $4bn in sales. The law of large numbers ensures this will be far more challenging. As the company scales up it will lose what made it nimble in the early days. It will need to work hard to seek out new markets and new geographies, each of which will entail new risks. And it will face more aggressive challenges from larger competitors defending their crown.

2. Reference to industry reports

Reference to an industry report often provides a veneer of credibility to an analyst’s assumptions. These reports like to supply a forecast for the expected size of a market by a certain point in the future. This can be a valuable resource for the analyst, and it appears relatively unbiased, but skepticism is still required. These forecasts usually suffer from the same optimistic bias that investors are subject to. Industry insiders often assume that benign conditions will continue far into the future, and they underestimate the challenges that industries face as they grow and mature. By all means, make use of insights from industry experts, but this should never be a replacement for your own judgment.

3. Management estimates

Again, these estimates are likely to suffer from an optimistic bias. Many management teams view it as their job to “sell” the story to investors and you won’t always be getting a balanced view. While management’s outlook should be considered, usually they have no more clue of what’s round the corner than you or I do.

4. High terminal growth rate

Terminal growth is the one figure that’s hardest to estimate, yet is likely to have the greatest impact on the result. A high growth rate combined with a high ROIC in the terminal year can drive quite spectacular price targets. I always look at the split in the valuation between the explicit period and the terminal growth period. Where the terminal growth period consists of a large part of the overall valuation, you need to scrutinize the assumptions with particular care.

When it comes to constructing your own revenue forecast, there are no easy answers. You will probably want to refer to multiple sources, but ultimately it will come down to your own (necessarily subjective) judgment, based on the markets in which the company operates.

To ensure an analyst hasn’t got carried away, I like to sense-check against the empirical evidence. McKinsey have done a valuable study of over 5,000 US non-financial companies between 1963 and 2007. They come to some very interesting conclusions:

1. The median rate of revenue growth between 1963 and 2007 was 5.4 percent in real terms. Real revenue growth fluctuates more than ROIC, ranging from 0.9 percent in 1992 to 9.4 percent in 1966.
2. High growth rates decay very quickly. Companies growing faster than 20 percent (in real terms) typically grow at only 8 percent within five years and at 5 percent within 10 years
3. Extremely large companies struggle to grow. Excluding the first year, companies entering the Fortune 50 grow at an average of only 1 percent (above inflation) over the following 15 years.

Of course, these numbers reflect averages and there are always outliers. But before concluding whether you have an outlier, it’s worth asking if this company really is all that different to the average.

I applaud anyone who does the hard work of coming up with a DCF valuation – it’s not an easy thing to do and the subjectivity of assumptions open you up to criticism. However used in the correct way, I believe it’s an indispensible tool to identify undervalued companies. Continued discussion around the assumptions can only be a positive, and this is exactly what we aim to promote within the StockViews community.