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June 8, 2019 - January 8, 2024
when listeners are absorbed in a story, they become more willing to accept arguments uncritically, that is, to drop their guard.
Stories create connections and get remembered, but numbers convince people.
In practice, and especially so in business and investing, that advice is ignored, and estimates are treated as facts, often leading to disastrous consequences.
One of the key findings in behavioral economics is that our response to numbers depends not only on their magnitude but also on how they are framed. That is the weakness that retailers exploit when they mark up the price on an item to $2.50 and take 20 percent off, since shoppers seem more inclined to buy that item than a similar one priced at $2.00.
If your defense against the outsourcing is that you have better data and more powerful computers than most other people, you open yourself up to a second problem, which is that a purely number-driven decision process is easy to imitate. Thus, if you are a “quant hedge fund” and build an elaborate quantitative model to find the best stocks to buy and sell, all I would need to do is be able to see the stocks you buy and sell, and with a powerful enough computer of my own, I should be able to replicate your strategy.
Let’s assume that you live in big data heaven, where you and everyone else has huge databases and powerful computers to analyze and make sense of the data. Since you all share the same data, and perhaps even use the same tools, you are going to highlight the same opportunities, generally at about the same time, and seek them out for profit. That process is going to create “herding,” when you buy and sell the same stocks at the same time. So what? That herding will create momentum, which will reinforce your decisions at least in the short term but will also cause you to be collectively wrong if
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As a general rule, I find it useful when I sample data to also take a look at the data I exclude from my sample, just to be aware of biases.
Professor Brown argued that the mistake many analysts were making was that they were starting with the hedge funds in existence today and working backward to see what returns those funds earned over time. By doing so, the analysts were missing the harsh reality of the hedge fund business, which is that the worst-performing hedge funds go out of business and not counting the returns from those funds pushes up the computed return for the sample.
Put simply, any perpetual growth rate that exceeds the nominal growth rate of the economy is impossible.
When valuing a business, you start by valuing its existing investments and then augment that value with the value created or destroyed by growth, before adjusting for risk in the cash flows.
Going concern terminal value n = E(Cash flow n +1)/Stable growth cost of capital − Growth rate)
growth rate in the terminal value equation has to be less than or equal to the nominal growth rate in the economy (domestic or global) in which the company operates. I would tighten that constraint by suggesting that the risk-free rate be used as the proxy for nominal growth in the economy, thus bringing the currency choice into the growth estimate; if you are working with a higher-inflation currency, both your risk-free rate and expected growth rate in perpetuity will be much higher.
Terminal reinvestment rate = Stable growth rate/Return on invested capital
if the return on capital you generate is equal to your cost of capital, the terminal value will not change as growth changes, since growth becomes a neutral variable.
The value added by your growth estimate in stable growth is a function of whether you believe that a firm can maintain its competitive advantages in the long term. If it cannot, its return on capital will drop back to its costs of capital, and the growth rate that you assume will have no effect on value.
Lease commitments, for instance, should be considered as debt and brought into your debt number, making a significant difference in the debt value at retail firms and restaurants, which have substantial operating leases.
If you can, you should value the parent company based on just parent company financials and then value each subsidiary separately (with its own growth, risk, and cash flow characteristics), take your proportionate holding in each one and add up the values.
As you forecast changes in your company’s growth and business mix over time, you should expect your discount rate to change as the company changes. In fact, even if your company’s business mix stays static, the mix of debt and equity that it uses can change over time, and as that mix changes, so will the discount rate.
Marginal return on capital = Change in operating income/ Reinvestment This marginal return on invested capital is a rough measure of how good you think your company’s investments will be in the future. If it is too high or too low, and that judgment can be made by comparing it with the company’s cost of capital, its historical return on capital, or industry averages, it is a red flag that you should revisit your growth and reinvestment assumptions.
Since these future equity issues are made to cover the negative cash flows, you are capturing the dilution effect by taking the present value of these cash flows into your consolidated value. Put simply, there is no need to estimate and adjust for future share issuances in your share count in a DCF valuation, because it is already in your value.
