James Montier Looks at the Flaws of DCF Models

In this paper, James Montier points out the absurdity of using the Discount Cash Flows model to value financial assets. Our empirically proven  inability to forecast cash flows far into the future and the extreme difficulty of defining a proper discount rate substantially limit the usefulness of the model. The author points out three alternative methods as a way to measure value.  The paper is well worth the read in its entirety, but here is a quick summary of the main points:

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3 thoughts on “James Montier Looks at the Flaws of DCF Models”

  1. Pingback: Hot Links: Humanity on Wall Street. Sure. The Reformed Broker

  2. I understand what you say but Warren B said that hed rather be …” vaguely right than precisely wrong”

    Why split hairs about what equity risk premium to use and what growth rates to apply? – If a company passes the Warren and Graham balance sheet and other tests then i just use a standard 6% equity risk premium and apply accross the board assumpions on growth which the same for all

    This gives me a ball park area for the purchase price and using stnadard grwoth assumptions means i can compare and contrast 2 possible euqity opportunities against each other and decide which one or how much of both to buy – seems to work sweet for me and no Black n’ Scholes anywhere to be seen!

    I like Graham’s other two methods of calculating value and use them as well but more as a check on the DCF result.

  3. Those who use DCF rely mainly on sensitivity analysis, where different scenarios of growth and required risk are applied. If under the worst case scenario there is margin of safety, a position is considered for further investigation. Even with this approach, there is too much guesswork involved when it comes to cash flows forecasting. There are way too many factors that can impact a company’s earnings power and some of them simply cannot be quantified.

    Beta is not a good measure of risk and it should not be incorporated in calculating the required rate of return. Correlations between stocks and between asset classes change all the time.

    Value investors need to concentrate on three types of risk:
    – valuation risk (function of liquidity);
    – finance risk (earnings power = ROC + earnings yield);
    – balance sheet risk (solvency risk).

    From my perspective, there is no such thing as true intrinsic value. It is an illusion, a moving target.

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