16.1 – The follies of DCF Analysis
In this concluding chapter, we will discuss a few important topics that could significantly impact the way you make your investment decisions. In the previous chapter, we learnt about the intrinsic value calculation using the Discounted Cash Flow (DCF) analysis. The DCF method is probably one of the most reliable methods available to evaluate the intrinsic value of a company’s stock. However, the DCF method has its fair share of drawbacks which you need to be aware of. The DCF model is only as good as the assumptions which are fed to it. If the assumptions used are incorrect, the fair value and stock price computation could be skewed.
- DCF requires us to forecast – To begin with, the DCF model requires us to predict the future cash flow and the business cycles. This is a challenge, let alone for a fundamental analyst but also for the top management of the company
- Highly sensitive to the Terminal Growth rate – The DCF model is highly sensitive to the terminal growth rate. A small change in the terminal growth rate would lead to a large difference in the final output i.e. the per share value. For instance in the ARBL case, we have assumed 3.5% as the terminal growth rate. At 3.5%, the share price is Rs.368/- but if we change this to 4.0% (an increase of 50 basis points) the share price would change to Rs.394/-
- Constant Updates – Once the model is built, the analyst needs to constantly modify and align the model with new data (quarterly and yearly data) that comes in. Both the inputs and the assumptions of the DCF model needs to be updated on a regular basis.
- Long term focus – DCF is heavily focused on long term investing, and thus it does not offer anything to investors who have a short term focus. (i.e. 1 year investment horizon)
Also, the DCF model may make you miss out on unusual opportunities as the model are based on certain rigid parameters.
Having stated the above, the only way to overcome the drawbacks of the DCF Model is by being as conservative as possible while making the assumptions. Some guidelines for the conservative assumptions are –
- FCF (Free Cash Flow) growth rate – The rate at which you grow the FCF year on year has to be around 20%. Companies can barely sustain growing their free cash flow beyond 20%. If a company is young and belongs to the high growth sector, then probably a little under 20% is justified, but no company deserves a FCF growth rate of over 20%
- Number of years – This is a bit tricky, while longer the duration, the better it is. At the same time longer the duration, there would be more room for errors. I generally prefer to use a 10 year 2 stage DCF approach
- 2 stage DCF valuation – It is always a good practice to split the DCF analysis into 2 stages as demonstrated in the ARBL example in the previous chapter. As discussed ,In stage 1 I would grow the FCF at a certain rate, and in stage 2 I would grow the FCF at a rate lower than the one used in stage 1
- Terminal Growth Rate – As I had mentioned earlier, the DCF model is highly sensitive to the terminal growth rate. Simple thumb rule here – keep it as low as possible. I personally prefer to keep it around 4% and never beyond it.
16.2 – Margin of Safety
Now, despite making some conservative assumptions things could still go wrong. How do you insulate yourself against that? This is where the concept of ‘Margin of Safety’ would arrive. The margin of safety thought process was popularized by Benjamin Graham in his seminal book titled “Intelligent Investor”. The ‘margin of safety’ simply suggests that an investor should buy stocks only when it is available at a discount to the estimated intrinsic value calculation. Following the Margin of Safety does not imply successful investments, but would provide a buffer for errors in calculation.
Here is how I exercise the ‘Margin of Safety’ principle in my own investment practice. Consider the case of Amara Raja Batteries Limited; the intrinsic value estimate was around Rs.368/- per share. Further we applied a 10% modeling error to create the intrinsic value band. The lower intrinsic value estimate was Rs.331/-. At Rs.331/- we are factoring in modeling errors. The Margin of Safety advocates us to further discount the intrinsic value. I usually like to discount the intrinsic value by another 30% at least.
But why should we discount it further? Aren’t we being extra conservative you may ask? Well, yes, but this is the only way you can insulate yourself from the bad assumptions and bad luck. Think about it, given all the fundamentals, if a stock looks attractive at Rs.100, then at Rs.70, you can be certain it is indeed a good bet! This is in fact what the savvy value investors always practice.
Going back to the case of ARBL –
- Intrinsic value is Rs.368/-
- Accounting for modeling errors @10% the lower intrinsic band value is Rs.331/-
- Discounting it further by another 30%, in order to accommodate for the margin of safety, the intrinsic value would be around Rs.230/-
- At 230/- I would be a buyer in this stock with great conviction
Of course, when quality stocks falls way below its intrinsic value they get picked up by value investors. Hence when the margin of safety is at play, you should consider buying it as soon as you can. As a long term investor, sweet deals like this (as in a quality stock trading below its intrinsic value) should not be missed.
Also, remember good stocks will be available at great discounts mostly in a bear market, when people are extremely pessimistic about stocks. So make sure you have sufficient cash during bear markets to go shopping!
16.3 – When to sell?
Throughout the module we have discussed about buying stocks. But what about selling? When do we book profits? For instance assume you bought ARBL at around Rs.250 per share. It is now trading close to Rs.730/- per share. This translates to an absolute return of 192%. A great rate of return by any yardstick (considering the return is generated in over a year’s time). So does that mean you actually sell out this stock and book a profit? Well the decision to sell depends on the disruption in investible grade attributes.
Disruption in investible grade attributes – Remember the decision to buy the stock does not stem from the price at which the stock trades. Meaning, we do not buy ARBL just because it has declined by 15%. We buy ARBL only because it qualifies through the rigor of the“investible grade attributes”. If a stock does not showcase investible grade attributes we do not buy. Therefore going by that logic, we hold on to stocks as long as the investible grade attributes stays intact.
The company can continue to showcase the same attributes for years together. The point is, as long as the attributes are intact, we stay invested in the stock. By virtue of these attributes the stock price naturally increases, thereby creating wealth for you. The moment these attributes shows signs of crumbling down, one can consider selling the stock.
16.4 – How many stocks in the portfolio?
The number of stocks that you need to own in your portfolio is often debated. While some say holding many stocks help you diversify risk, others say holding far fewer helps you take concentrated bets which can potentially reap great rewards. Here is what some of the legendary investors have advised when it comes to the number of stocks in your portfolio –
Seth Kalrman – 10 to 15 stocks
Warren Buffet – 5 to 10 stocks
Ben Graham – 10 to 30 stocks
John Keynes – 2 to 3 stocks
In my own personal portfolio, I have about 13 stocks and at no point I would be comfortable owning beyond 15 stocks. While it is hard to comment on what should be the minimum number of stocks, I do believe there is no point owning a large number of stocks in your portfolio. When I say large, I have a figure of over 20 in my mind.
16.5 – Final Conclusion
Over the last 16 chapters, we have learnt and discussed several topics related to the markets and fundamental analysis. Perhaps it is now the right time to wrap up and leave you with a few last points that I think are worth remembering –
- Be reasonable – Markets are volatile; it is the nature of the beast. However if you have the patience to stay put, markets can reward you fairly well. When I say “reward you fairly well” I have a CAGR of about 15-18% in mind. I personally think this is a fairly decent and realistic expectation. Please don’t be swayed by abnormal returns like 50- 100% in the short term, even if it is achievable it may not be sustainable
- Long term approach – I have discussed this topic in chapter 2 as to why investors need to have a long term approach. Remember, money compounds faster the longer you stay invested
- Look for investible grade attributes – Look for stocks that display investible grade attributes and stay invested in them as long as these attributes last. Book profits when you think the company no longer has these attributes
- Respect Qualitative Research – Character is more important than numbers. Always look at investing in companies whose promoters exhibit good character
- Cut the noise, apply the checklist – No matter how much the analyst on TV/newspaper brags about a certain company don’t fall prey to it. You have a checklist, just apply the same to see if it makes any sense
- Respect the margin of safety – As this literally works like a safety net against bad luck
- IPO’s – Avoid buying into IPOs. IPOs are usually overpriced. However if you were compelled to buy into an IPO then analyze the IPO in the same 3 stage equity research methodology
- Continued Learning – Understanding markets requires a lifetime effort. Always look at learning new things and exploring your knowledge base.
I would like to leave you with 4 book recommendations that I think will help you develop a great investment mindset.
- The Essays of Warren Buffet : Lessons for Investors & Managers
- The Little Book that Beats the Market – By Joel Greenblatt
- The Little Book of Valuations – By Aswath Damodaran
- The Little Book that Builds Wealth – By Pat Dorsey
So friends, with these points I would like to close this module on Fundamental Analysis. I hope you enjoyed reading this as much as I enjoyed writing it.