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85 - Precisely Wrong, Roughly Right (DCFs)

The DIY Investing Podcast

Release Date: 07/27/2020

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More Episodes

Mental Models discussed in this podcast:

  • Discount Rates
  • Gordon Growth Model
  • Discounted Cash Flow Calculation

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Show Outline

The full show notes for this episode are available at https://www.diyinvesting.org/Episode85

Why DCFs should not be used 

  • What is a DCF?
    • An estimate of all future cash flow (dividends or earnings) and discounted back to the present.
    • When you add up these values you get the intrinsic value of a company.
  • Gordon Growth Model (perpetual constant growth of a dividend - DCF)
    • P = Div (next year’s) / (r-g)
    • R = discount rate (10%)
    • G = constant growth rate in perpetuity.
  • Example:
    • Dividend = $1.64 (Coca-Cola)
    • Specific estimates: $27.85 (based on specific year estimates)
    • Growth rate: 3% = $23.42 (equivalent to a 7% dividend yield)
    • Growth rate: 5% = $32.80 (equivalent to a 5% dividend yield)
    • Current price: approx. $46 per share
    • Always invert.
      • Dividend yield of 3.5% or growth rate of 6.5% in perpetuity.
  • Example 2: P/E ratios for growing companies.
    • I want to estimate how quickly I can reach a 10% earnings yield.
    • I want it to be less than 5 years.
      • Without compounding this means a 10% grower you can pay P/E of 15.
      • A 20% grower you can pay P/E of 20.
      • All of these imply you can sustain that growth for 5 years.
      • Why ignore compounding? It’s simpler and conservative. 

Summary:

Discounted Cash Flow calculations and models provide precise estimates of intrinsic value but tend to be flawed. It is much better to improve accuracy by ignoring DCF and using a simple intrinsic value calculation like the Gordon Growth Model.