Friday, 19 February 2016

discounting cash flow

Companies have been valued using something like discounted cash flows (DCF) for quite a few decades now.  In the field of equity analysis, this has become something close to a standard approach.  Equity analysts would also have you believe that this is not enough, and that their 'special sauce' is what adds value to an opinion free valuation.

Buf if the theory of coherent arbitrariness is true, then perhaps the DCF approach can be bettered?  Or certainly better understood.  The essence of the DCF approach is that you imagine all the major epected cash flows that arise during the future life (or next few years) of the company.  You then find the net cash flows (that is, you balance off the incoming with the outgoing expected cash flows and consider what remains) all in a way which respects the time value of money - that is, which performs a discounting operation on those cash flows, at the appropriate level of discounting.  The present value of these net cash flows is then considered to be the fair value of the equity of the company (regardless of whether this company is listed or not).

Coherent arbitrariness states that we humans are useless at coming up with absolute (cash based) fair values, but at least somwehat better at deciding of one value is greater than another - relative valuations. 

Imagine this is also true with respect to DFC.  When you break DFC analysis down into its consituent parts, there are essentially two operations being performed.  First, the correct collation of all the relevant cash flows.  These are future cash flows, so there is some guesswork going on here.  Some of those  cash flows are easier to collate than others.  For example, debt payments are quite well defined.  Expected sales aren't.  Expected sales depends on an opinion on growth (or contraction) of that market, and the likely execution of operational and strategic factors, ranging from upscaling new plant to integrating new mergers.

Under coherent arbitrariness, this is all largely making a stab in the dark.  The part which relativises the set of expected cash flows is the choice of the discounting factor.  The discount factor turns what is a cash flow based analysis into a relative one, since the discount factor chosen is often so opinion based and variable that it essentially makes the cash flow analysis meaningless as a single company analysis.  What you're doing really is making a set of industry predictions which are encoded in relative discount factors.  You are then giving yourself so much room in these relative discounting factors that the cash flows themselves lose their stand alone predictive value and become a set of very loose constraints on what is essentially a relative value estimation.

The cash flow analysis ought to be commoditised and available as a release of the corporate finance department.  This then can be a common basis for the equity analyst to make what-if adjustments to the relative discounting factors, and the cash flows, if they really feel strongly about it.

Contingent cash flows - for example, the expected sales figures, ought then to become a kind of bond call option, presented to the equity analyst to apply or override the volatility and possibly the strke.  All aspects of the estimation process ought to become real options or fixed income based.  Analysis can then more honestly be focused on the relative distribution of parameters to these financial instruments.  Modelling a company then becomes the act of taking an agreed reference model and then setting real options parameters to it.  The analyst community should jointly construct and share the set of real options which define any specific company.

In short my suggestion is to, for better or worse, to make each company become described by a single commulity based reference model of financial instruments, including real options.  Then reveal equity analysis as a two part operation - the discovery of this community agreed set of instruments - together with a set of clearly defined parameters for these options.