In my prior post, I discussed the Constant Dividend Growth Model. In this post, I will discuss other valuation methods. Are these others more in use or more practical than the Constant Dividend model? Yes, they are more practical for private (i.e., not publicly-traded) investments, maybe less so for stock investing.
Discounted Cash Flow
Related to the Constant Dividend Growth Model is the Discounted Cash Flow (DCF) method. In the DCF method, the modeler projects the investment’s cash flows, both outflows and inflows, over the entire cost of the full investment period. Legions of financial analysts on Wall Street and in financial centers all over the country are intimately familiar with DCF modeling. Microsoft Excel is the software king in this space. How quickly one can model is a source of pride for these analysts, and it can result in strong raises and bonuses.
The modeler starts in Year 0 with the full cost of the acquisition of the investment. That cell will be a negative number because it is cash outflow. Subsequent Years will be either positive or negative, depending on whether the investment throws off cash flow or requires additional investment. Finally, it is assumed the investment is sold at some point in the future. That will be a positive cash flow to the owner.
All of these cash flows are mathematically discounted at some hoped-for return number. Perhaps I should have previously had a post about the Time Value of Money, but suffice it to say that $100 3 years from now is not worth as much as $100 today because of inflation, opportunity cost, and other factors. Hence, the discounting rate. If you hope to earn 10% on this investment, then discount the cash flows by 10%. If the resulting number after discounting at your required rate is a positive number, then you should make the investment. If the resulting number is negative, then don’t make the investment, or negotiate the initial investment price down so that the resulting discounted number will be positive.
Internal Rate of Return
If the resulting number after the discounting exercise is Zero, then you have successfully calculated the investment’s Internal Rate of Return, or IRR. Being able to calculate and then to communicate the IRR is a very important Financial skill. It’s required in an elevator pitch – or in a handshake pitch. As in, “I have an investment in a small plating business that’s a 13.4% IRR. Are you interested?” Or: “My apartment building is 97% occupied with a 12.8% IRR.” A great, quick way to communicate that something is a good investment.
IRR’s from different projects can then be compared with one another to determine which is the best investment, at least on paper. The Comparison Method has many forms, and it is probably the most used method of evaluation of investments. Usually, you think of a real estate appraisal: An appraiser compares the house you are interested in with others that have sold in the marketplace (i.e., comparables), and makes adjustments up or down depending on differences between the subject property with the comparables. Likewise, you can compare the stock you are interested with others based on some metric such as the Price/Earnings Ratio (PE), or even maybe dividend yield. Why should I invest in this investment when this other one over here is at a lower PE? That question implies you are using the Comparison Method to evaluate your investment.
DCF or IRR-type methods are useful for private investments, but only somewhat. Why only somewhat? Because of the level of reliability of the assumptions in the cash flow model. It is very difficult to model accurately the cash flows of an investment over the next several years. There are too many variables and unknown unknowns (Rumsfeld) that could occur. Additionally, as with the Constant Dividend Growth Model, the DCF/IRR is not as useful for investments in the stock market because you don’t have control over the use of the company’s cash flow. The Comparison Method is more useful, but the main problem is, in any investment, What if the basis of comparison, i.e., your comparable, is wrongly valued or just plain wrong? Then you are comparing where you may invest your own money with something that is wrong. Conclusion: It is difficult to value an investment and have a strong level of confidence that the valuation is valid. You are always operating in the opaque. That’s why making money through investing is difficult.