People often ask me why I use the mechanical method of investing provided by The Acquirer’s Multiple versus The Discounted Cash Flow Model.
The answer can be found in this excerpt from the book, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by the founder of this website, Tobias Carlisle.
“Shortly after Graham published Security Analysis in 1934, John Burr Williams published his 1938 masterpiece The Theory of Investment Value. Williams’s discounted cash flow theory of intrinsic value is the bedrock of modern valuation and forms the intellectual basis for a variety of valuation models.”
“The models all require an estimate for future cash flows, earnings, or dividends, making allowance for any growth, and out to perpetuity.”
“Money has a time value—a dollar today is worth more than a dollar in a year—so we must then discount back to today those future cash flows at the appropriate discount rate. While the theory is sound, the slip ’twixt cup and lip is in its practical application.”
“The three variables—future cash flows, the growth rate, and the discount rate—are all sources of potential forecast error.”
“Discounted cash flow models are extremely sensitive to discount rates, which can lead to large errors, but the real problem is that the model assumes we have some way of forecasting future cash flows and the growth rates embedded in them.”
“Time and again, we have been shown to be poor forecasters, preferring to extrapolate the current trend, rather than assume mean reversion. Kahneman and Tversky call this the “misconception of regression,” and it rears its head time and again in investment.”
“Studies of financial analysts’ earnings forecasts, for example, have found them to fail to incorporate into the forecast an expectation of mean reversion when it is bound to occur, and therefore to deliver results that are no better than random chance.”
“In 2007 Roy Batchelor examined the records of financial analysts over the period 1990 to 2005, and found them to be consistently wrong, persistently erring on the side of over-optimism because they extrapolated up an existing trend without allowing for mean reversion.”
“Figure 6.2 is a chart showing Batchelor’s finding that analysts tend to be too optimistic. The chart shows that forward earnings forecasts are rarely correct and tend to overshoot actual earnings. Batchelor finds this bias to over-optimism to be systematic. The size of the forecast error declines when economic growth accelerates and increases when economic growth slows.”
“In Batchelor’s research, actual earnings beat the forecasts only twice in 25 years—both times during recoveries following a recession.”
“When the forecasts did hit the target it was because the underlying economic growth was unusually strong, which is to say the forecast turned out to be right because the usual assumptions in the forecast were wrong. The analysts missed completely any turn in the fortunes of the market or the economy. Like naïve extrapolation investors, they failed to account for any possibility of mean reversion when mean reversion is the probable outcome.”
“Tellingly, increased sophistication—more powerful computers, more arcane models, and mountains of historical data—had not improved the accuracy of their forecasts. There is no evidence that their ability has increased since the 1970s (if anything, the evidence is that it has deteriorated over time).”
Now, I’m sure many of you have had lots of success calculating valuation using the discounted cash flow model. But for me as an individual investor, I just find it too damn hard to calculate valuation accurately using future cash flows, growth rates, and discount rates, and that’s why I stick to The Acquirer’s Multiple.
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