QUESTION: So the intrinsic value of a company is the present value of all future cash flows?
CSInvesting: Yes, a pension fund may be fine with a discount rate of 8.5% but you require 15%.
I don’t know what discount rate they are using, but when you see a company trading at $15 and you think it is worth, then probably your valuation is off. Markets are not ALWAYS inefficient, but they are usually not GROSSLY inefficient. Say, you value a miner based on today’s gold price of $1,200 and it trades at triple the price in two years but the gold price trades at $1,600 (US) then a speculative element changed your valuation.
I think you are double counting. You use 20% discount rate when usually the cost of equity capital is 7% to 11% AND it trades at a 50% discount, then your valuation is probably in fantasy land.
DANGER with USING DCFs
- The Problems with DCF My readings
- Common Errors in DCF Models – Do You Use Economically Sound and Transparent Models (03.16.06)
- Dangers of DCF_Mortier
Chapter 8 Cost-of-Equity-Capital Credit Model by Hackel
The analysis of risk represents the single most underexplored factor in security research and the primary reason for investor disappointment in their investment returns.
The cost of equity capital, while known as a measure of investors’ attitudes toward risk, more aptly should represent the uncertainty to the cash flows investors can expect to receive from their investment in the security being considered. Only through n accurate and reliable cost of equity capital can fair value be established as well as the determination of whether management is creating value for shareholders, as measured by the return on invested capital (ROIC) in comparison with its cost.
Because security analysts are not confronted with the daily barrage of problems and hazards that managers and executives working directly for the entity face a wide swath of hidden risks that tends to be ignored or not calibrated properly. Investors need to think and behave like corporate insiders to truly appreciate this multitude of exposures so as to accurately place a cost of capital that takes into account these uncertainties, of which any one could damper cash flows or even threaten the entity’s survival. On the other hand, if investors were to overweigh such risks, the entity’s valuation multiple would depress, causing misevaluation.
Say the standard tech company has a cost of capital of 9%. Well, Apple’s might have a lower, 7.6% cost of equity capital, because of the lower operational risk of its business as noted by the cost of its credit.
Use a credit model for the cost of equity capital –See ch. 8: Security Valuation and Risk Analysis by Kenneth Hackel. (in Value Vault)
At least you are garnering a different perspective. Good questions.