The Amateur Investor Ep.10: No Crystal Balls Here

In June of 2018, as part of some misguided attempt to see how far I could push myself, and inspired by Jimmy Chin and Conrad Anker’s first ascent of Meru Peak, I signed myself up to an alpine mountaineering course. Hosted in New Zealand’s South Island, on Mt Cook, the course featured 5 days of avalanche training, snow craft, and alpine climbing. The hike up to Caroline Hut where we would be based was not easy in the least, but that’s a story for another time. The five days were filled with a lot of content, learning about how to test snowpack for stability, what it looked like when it was likely to avalanche versus what it looked like when it was stable enough to put weighted anchors into. On the third day, we hiked hard out to a nearby peak and sat in the snow, looking out over the valley. From where we sat, we could see the hut we slept in below us and much of the mountain range. For the next half hour, we learned about reading the weather, using wind gauges, and our eyes to check conditions and read cloud patterns. Interesting when you’re just sitting out on the snow having a rest, vital when you’re pushing through the snow uphill, and want to take shelter before adverse weather kicks in and ruins your day.

Forecasting is important. In almost anything, some measure of forecasting is good. On the small-scale, it’s a matter of preplanning and preparing for any potential obstacles that may crop up along the way. As we proceed toward the macro-end of the scale, it becomes more about preparing as best you can and less about active prevention. That is the thing with stock valuations. Investors on the whole are risk averse, we do our valuations to try to take the guesswork and fear out of investing by looking at the book, checking out management and looking at the industry, but that still doesn’t account for the unforeseen. We can know that the managers are smart as whips, all with amazing resumes, but like Hsuan often says, it doesn’t account for the CEO being caught with his hand in the till, or in someone else’s pants. 

Mountaineering stories and corporate misconduct aside, another useful measure for looking at how a company is doing, and how it may do in the future, is to look at it’s Discounted Cash Flow (DCF). Now, I put some of that fiddle faddle up top by way of an apology, because much like the last issue, it might get a little content heavy. As a method of valuation, DCF is used to estimate value based on future cash flow, appropriate for any case where you’re investing money now in the hope of receiving a good return on your investment in the future. Where it’s probably not the best is when you come up to more complex projects or where future cash flow values are not available.

Anyway let’s get down to brass tacks.

(DCF) = CF1(1+r)^1+CF2(1+r)^2+CF3(1+r)^3+CFn(1+r)^n

• CF is the total cash flow for a given year, CF₁ being the first year, CF₂ being the second, etc.
• The r value is for the discount percentage expressed as a decimal. This is governed by the rate of return you’re hoping to get on your investment. It can also be used as an indicator of perceived risks.

In broad strokes, Discounted Cash Flow is used to translate the future cash flow from an investment into today’s value via the compounded rate of return you could achieve with the money you have right now. It’s key assumption is that cash now is better than probable cash in the future.

Let’s look at an example. 

Say you’re looking to invest in a company, let’s call it Avian. The company lists a guaranteed 10% per annum return on investment. Now, like any good investor, you start looking into the company and decide that it’s worthwhile. So let’s say Avian is offering you that 10% on your return, and you’ve got $10,000 you’re looking to invest, with a period of say, three years, which should result in $13,310. 

$10,000 =$13,310(1+0.10)3

That’s what you would be looking to invest, which is called a fair value investment. Now say for example you find out some shady stuff about the company. That’s when you implement what is known as a Margin of Safety (Seeking Alpha), a discount applied to cover what you need to compensate yourself for the risk of the investment. Probability black magic aside, let’s assume that there’s a 20% chance that there will be some problem with the company that will render them unable to fulfill that advertised 10% return. Applying this margin then reflects as the following.

0.8*$10,000 = $8,000

Basically, with the added risk, the investment of $10,000 is really only worth $8,000. The $2,000 is the compensation you would need to cover for the risk that your investment will not see the allotted returns.

That’s more or less what DCF is, and there’s a bunch of ways in which this can be used. For a pure cash flow model, you could take the DCF over a number of years and calculate that with no discount. A more thorough approach might be to look at the books over the last ten years, with an arbitrary discount percentage to accommodate for risk. A few investors will just use the interest rate to calculate their DCFs, using PE values to forecast on share prices. Much like PE values, it should not be used on its own to guide investment strategy, but rather as part of a whole puzzle. I should note at this point that DCFs don’t account for dividends, which can skw your valuation somewhat. 

The science is by no means accurate, in fact it’s all quite fuzzy.

Next week hopefully we’ll have something to account for that. I write this noting that it’s Thursday, about two days after when I usually try to publish, so it might be delayed again while I do my homework.

So for now, and I’m sure you’re tired of hearing me say this, but it bears repeating, no matter where you are.

Go slow, play small and learn the process

P.S. I apologize for the scientific calculator symbols in the equations. Turns out WordPress doesn’t like equations. I found this out after posting it and almost had an aneurysm.

Additional Reading list

• https://www.lynalden.com/discounted-cash-flow-analysis/
• https://macabacus.com/valuation/dcf/overview
• https://www.investopedia.com/terms/d/dcf.asp#:~:text=Discounted%20cash%20flow%20(DCF)%20is,will%20generate%20in%20the%20future.
• https://seekingalpha.com/article/462411-discounted-cash-flow-what-discount-rate-to-use#:~:text=The%20discount%20rate%20is%20by,15%25%20return%20on%20your%20investment.