Inverted DCF Is A Great Way To Value Businesses

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During his recent interview with Tobias, Dan Ferris, editor of Extreme Value, discussed how Inverting A DCF Is A Great Way To Value Businesses. Here’s an excerpt from the interview:

Tobias Carlisle:
How do you think about valuation? Finding those things can be … it’s not … I wouldn’t say it’s easy, but you can find those things in the market. The challenge, then, is finding them at a reasonable price, but how do you know when you’re looking at something is this a reasonable value or it it not?

Dan Ferris:
Okay. This is a big topic for me because I learned to flip this. The old way of discounting cash flow, you sit down and you project. You predict, basically. You say, “They’re probably going to do this much in year one and this much in year two, three, four, ten,” and then you put some kind of terminal value on the end of it, but you’re basically predicting the future there. That has always bothered the hell out of me, because I don’t know the future.

Tobias Carlisle:
What’s the solution?

Dan Ferris:
The solution, I believe, is … I got this from reading a book called Expectations Investing by Michael Mauboussin and Alfred Rappaport. You flip the thing on its ear and instead of predicting the future and discounting that and arriving at a value and trying to buy at a discount to that value, what you do is you plug in those inputs for the future to equal the current share price. So you’re basically asking, “What is the market saying at this share price?” And if the market is saying, “Starbucks can’t grow for another five or ten years,” I’m going to call BS on the market and I’m going to say, “I think it can,” and buy it. That was an example from the Extreme Value newsletter. We looked at that and we thought, “This is absurd. Zero growth for Starbucks is absurd,” and it turned out to be a pretty good deal, I think.

Dan Ferris:
So it’s that. It’s flipping the process around and doing the plug ins for the future cash flows and it’s really revenues, operating margins and free cash flow, operating in free cash flow. Then seeing what that says about the current share price. Sometimes it says the market is expecting a lot. Sometimes it’s all the expectations are in line with everything management is saying and everything that people expect in general and sometimes there’s pessimism built into that and that’s when we pounce.

Tobias Carlisle:
I like that. That makes a lot of sense.

Dan Ferris:
It sounds so easy, doesn’t it?

Tobias Carlisle:
Yeah. Easy to put into practice.

Dan Ferris:
Yeah. It’s not.

You can find out more about Tobias’ podcast here – The Acquirers Podcast. You can also listen to the podcast on your favorite podcast platforms here:

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