Useful Accuracy - notes from talk with Dr. Damodaran

"DCF and the Hubble Telescope", this is the provocative title to a presentation by Rajeev Thakkar, CFA, in April 2018.  Thakkar's presentation is primarily about input sensitivity of Discounted Cash Flow (DCF) models. Thakkar did not discuss the exact DCF model he used but provided enough information to figure it out.  The presentation starts off with a table showing input values and resulting DCF values for 3 scenarios - A, B, C.  B is the base case, most likely scenario.  A is the optimistic scenario and C is the pessimistic scenario.  Each scenario uses the same starting cash flow but different inputs for cash flow growth (g1, g2) and equity cost of capital (CoC1, CoC2).

Thakkar makes references to Dr. Damodaran several times during his presentation, so it seemed likely he used a model based on Damodaran's teachings.  Since the table included 2 growth rates, next 10 years and terminal value, it seemed logical he used Damodaran Two-Stage growth model.  Running Thakkar's numbers through the following Damodaran formula validated the model used.

Damodaran Two-Stage Valuation Model:

DCF = Present Value of Stage 1 Cash Flows

         + Present Value of Terminal Value

         = (Starting Cash Flow)(1+g1)(1-(((1+ge1)/(1+CoC1))^10))/(CoC1-g1)

         + (Starting Cash Flow)(1+g2)     (((1+ge1)/(1+CoC1))^10) /(Coc2-g2)

Varying g1, g2, CoC1, and CoC2 as shown in Thakkar table results in DCF of 306, 720, and 157 for the base, optimistic, and pessimistic scenarios.  What struck me odd was the use of a exacting formula with uncertain inputs.  To me, Thakkar's presentation was more of a statement about the art of valuation.  Damodaran's Two-Stage valuation model is mathematical correct, but unlikely to produce more useful results then simpler formulas.  I think a more practical formula for valuation is the one used on the Polaris website, namely:

  DCF = (Dividend)(10)

           + (Current Sales)(1+gs2)((1+gs1)^10)((Future PM)/Future Shares))(Future PE)/((1+CoC1)^10)

The first part of the formula omits the growing of dividends and discounting back because they tend to cancel each other out.  The second part of the formula uses well known ratios - Profit Margin (PM) and mean reverted Price/Earnings (PE).  Future Shares accounts for stock buybacks.  The formula is easily understood, add up dividends for the first 10 years and then add the present value of future sales per share times PM times PE.

I wondered what Dr. Damodaran thoughts were on this topic, so I discussed with him on 07/26/18.  I recently meet Dr. Damodaran by taking his Advanced Valuation Certification class.  Unlike courses offered by other universities, Dr. Damodaran was very accessible.

At the start of the video call, I could not help but notice Dr. Damodaran was enjoying his sabbatical.  He was in a lounge chair with the Pacific Ocean in the background.  Not to disrupt his time off too much, I jumped right into discussing valuation.  First off, Dr. Damodaran did not agree with the "Hubble Telescope" analogy.  He said valuation inputs do not typically vary independently of each other.  Changes to input values tend to offset each other resulting in a reasonable changes to DCF.

The rest of my conversation with Dr. Damodaran was primarily about false precision, using exact formulas with inexact inputs.  He said the preferred way to do DCF is to determine explicit cash flows for the first several years and add on a terminal value.  He said his Two-Stage valuation model is an approximation and the Polaris practical formula is a reasonable approximation as well.   Polaris practical formula shifts the inputs from cash flow growth and cost of capital to sales growth, PM, PE, and approximating future shares.  

There are defensible ways to forecast sales growth (analyst consensus forecasts), PM (industry historical average), and PE (McKinsey convergence), but approximating future shares is more difficult.  Dr. Damodaran referenced a blog he just posted the day before titled “Share Count Confusion" on his "Musing with the Markets" blog.  In the blog he discusses an alternative to compute DCF by excluding negative cash flows and forecasting the number of new shares to cover them, which is essentially what the Polaris practical formula does.  The blog suggests how to replace explicit negative cash flows with newly issued shares.  

Unfortunately, there was not enough time to discuss how to forecast new shares when using an approximation formula.  In a comment to his blog, I suggested calculating historical trend of shares growth to sales growth and multiplying by forecasted sales growth.  I hope to discuss this further with him.

This blog is a reminder that valuation is a craft consisting of some science and art.  It is important to keep the exactness of formulas and inputs in balance in order to end up with useful accuracy.

A Framework for Building Long-Term Wealth

The Story of Polaris Investing

Index Funds = Average Returns

Only a small percentage of Americans actively invest in the stock market. Most choose to settle on the sidelines and park their money in 401Ks, IRAs, and/or index funds that receive below-average to average returns at best. 

When they do decide to invest in individual stocks, they make their selections based on hot tips or hunches. Then, they are quick to reconsider, particularly when the stock market takes a downward turn. 

What these investors lack, according Daniel Crosby, author of Laws of Wealth, is clarity, courageousness, consistency and conviction.

There’s also this concept of value investing. Heck, most of the Polaris Team grew up in Omaha, Nebraska, literally in the shadow of the “Oracle of Omaha,” Warren Buffet. How could we not know that the secret of investing is to (1) figure out the value of something, and (2) pay less for it. As Warren is famous for saying, “price is what you pay, value is what you get.”

The team at Polaris searched high and low for an investment adviser or website that could provide us with a simple and easy-to-use tool built on time-proven principles of profitable investing. We came up empty-handed.

The Thoughtful Investing Tool

That’s when we decided to create one ourselves. Polaris is the result of over 10 years of research and testing into the fundamentals of stock market investing, and specifically, theories of asset valuation — what a particular company is worth at some future date. 

Polaris provides Clarity. It is straightforward and easy to use. Most investment advisors and websites throw a mountain of data at investors, using unclear or specialized language. In fact, many investment sites are merely news aggregators — pulling data and stories from many different sources and expecting the investor to make sense of it all.

We at Polaris believe that simplicity beats complexity! We rely on a few key financial and economic variables that have been shown to be at the heart of stock valuation. These include a company’s sales growth rate, profit margin and risk relative to the market. 

Using these variables, we first calculate a theoretical investment return. Then, using a propriety algorithm, we moderate the theoretical return, taking into consideration the stock’s current price, to arrive at a practical return.

Polaris provides courageousness. We know how emotionally hard it is to do the right thing, particularly during market downturns. And there will be market downturns — probably 10+ in your lifetime. 

With our unique Practical Buy/Sell Spectrum, we give you suggestions as to when to buy, when to sell and when to wait. By the way, unlike a lot of investment sites, we at Polaris think it is OK to wait on an investment decision. Which is we provide a Waitlist feature that allows you to easily retrieve stocks you are following.

Polaris provides consistency. It is a tool that can be used all the time; by providing a consistent and elegantly designed interface. In future releases, we will provide users with alerts indicating when a particular stock price has moved from Watch to Buy to Sell.

Polaris provides conviction. With our My Investment Plans page, you will be able to set a course of action and stick with it. Soon-to-be-released notifications will alert you when the stock price moves up and down the Buy/Sell Spectrum.

Think of it as a form of behavioral coaching. We try to prevent investors from making foolish decisions during times of market upheaval. Successful investing is not about beating others, but controlling oneself.

A Final Note

In our next blog, we’ll talk about the specifics of how to use the Polaris site to get off the sidelines and earn higher-than-average returns by making thoughtful investment decisions.

One of our favorite quotes here at Polaris is…

“When the short-term stock market rocks, sleep well knowing you have done the thoughtful thing.”

 — Paul Samuelson, Nobel Prize in Economics

7 ½ Reasons Why You Should Invest in Individual Stocks

Only 15% of US households own individual stocks. This figure has not changed much since the early 60s. But there are many good and important reasons to invest a portion of your assets in individual stocks. Here are 7.5 of them.

1—You get the lousy with the great. In a typical year, just 25% of stocks account for the majority of gains in the market. Investing in a diversified/index fund guarantees you own some of the top performers, but also guarantees you own many of the losers, resulting in average performance.

2—You will never beat the market. People can toss their investment money into index funds, sit back, and simply match the market. But you’ll never beat the market.

3—When everyone gets on the same side of the boat, it tips over. Active fund managers look for a needle in a haystack. Index fund managers buy the whole haystack. The biggest danger of index funds is when most people do it. When the majority of people avoid thoughtful, individual stock selection, there is even more opportunity for investors who pick individual stocks.

4—You sacrifice returns for safety. In the past 50 years, employers have changed from pension plans to 401Ks and IRAs. This has shifted investment decisions to the individual. Unfortunately, most individuals lack investment training and feel unprepared and end up fleeing to the average performance of index funds. But too much risk avoidance leads to return avoidance and stifles capitalism.

5—The dark side of index funds. Diversified/index funds use mostly mechanical criteria and rules in selecting stocks—making them mostly momentum funds. Momentum funds buy more of stocks that have been performing well recently. This passive, follower strategy works best in a rising market. In a falling market, diversified/index funds stay fully invested and continue to buy more of stocks that are not performing as badly as the rest. The mechanical nature of diversified/index funds makes them ill-suited for making above average returns.

6—Top performers will more than compensate for a few poor performers. With a disciplined approach, it is possible to invest more in gainers than losers. Stock returns are lumpy, so in a portfolio of 10–15 stocks, 1–2 will likely do extremely well, 3–4 will perform good, 6–7 will be average, and 2–3 will perform poorly. Uncertainty or risk around how individual stocks will perform is the ante required to earn higher-than-average returns.

7—Take a stand on how you want the world to work. Part of owning individual stocks is taking a stand on how you want the world to work. Investing in stocks requires a leader mentality and that you be a steward of society’s assets. By influencing the movement of capital to its most productive use, an individual investor enriches him/herself and improves the human condition. This is similar to the duty of voting in a democracy. Being a voter and investor are adult responsibilities.

7.5—Finally, a cynical way of thinking about index funds is that people investing in them believe thinking is a waste of time.

Want to know how to start investing in stocks using a simple, straightforward approach?

Check out polarisinvesting.com. You’ll sleep well at night knowing you made a thoughtful decision.