Mr Market has been particularly indecisive of late, with price volatility sucking up a lot of investors’ attention. As an active manager focused on generating risk-reward outcomes better than the overall market, we at Mint believe that investors need to keep their attention on value and try to ignore what prices are doing. To help investors maintain that focus we wanted to share some insight on a common tool for determining value: discounted cash flow (DCF) valuations.
In short, DCF valuation models are based on estimates of the business’ future cash flows, expressed in terms of today’s dollars using an estimate of business risk and the value of having money today vs. having it in the future. While there is much to say and cases to be made for using other valuation methodologies such as price multiples in certain scenarios, in this article we’ll focus on DCF models.
We believe that DCFs have many advantages for determining value including that:
Despite those (and other) advantages of DCF valuations, they aren’t infallible. Trying to estimate a business’ cash flows is not easy for most investors, including professional investors like us at Mint. This can lead to overcomplicated models, with many variables and lots of calculations. It’s easy to let
that complexity make you overconfident in your estimates and lead you to be too aggressive in your investment decisions. Moreover, being able to use more variables, including key business value drivers, is helpful, but doesn’t always lead to more correct estimates.
At Mint, we don’t exclusively use DCFs to value businesses, and our robust process helps us overcome the potential biases and traps they present. However, we do think they’re an effective tool in an investor’s toolkit and they force investors to be focused on value, not what Mr Market is telling them.
 If you aren’t familiar with it you can read about Mr Market in Benjamin Graham’s book, The Intelligent Investor, or get a brief summary here: Mr. Market - Wikipedia.
 This estimate is called the discount rate, and in very simple terms, this can be thought of like an interest rate in that it reflects the value of deferring consumption from today to the future and the risk that the investment amount might not be repaid.
 In short, we think they’re appropriate for making relative inferences of value for mature businesses.
 It’s not impossible, but the task gets more difficult given that the length and profile of growth can vary between businesses. This is another reason why multiples can get you stuck trying to do too much with too few variables.
 Here I would invoke and repurpose Warren Buffet’s caution on his investment process – it’s simple, but not easy.
 A excellent reading recommendation on this topic is Noise: A Flaw in Human Judgment by Daniel Kahneman (a winner of the Nobel Memorial Prize in Economics), Oliver Sibony and Cass Sustein.
Disclaimer: Sam Arcand is an Investment Analyst at Mint Asset Management Limited. The above article is intended to provide information and does not purport to give investment advice.
Mint Asset Management is the issuer of the Mint Asset Management Funds. Download a copy of the product disclosure statement here.
You've reached us out of office hours, but we're here for you...
Fill out the form below to log a request for a follow-up call or more information.
Our contact staff are available to provide fast follow-up to your questions from 8:30am to 5pm, Monday to Friday.