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DCF Model Cannot Be Applied to Unpredictable businesses like St. Joe

November 03, 2010 | About:


There has been wide coverage over the clash on the valuations of St. Joe company between Bruce Berkowitz and David Einhorn. Both of them are great value investors. But they have contrary views on St. Joe. Bruce Berkowitz is buying the shares, and wants to buy all the shares if possible, while David Einhorn is shorting the stock.

These are the related articles we have published about this topic:

In this article we do not intend the evaluate St. Joe, and we are not siding with either Mr. Berkowitz or Mr. Einhorn. We would like to take this opportunity to explain the limitations of the discounted cash flow (DCF) model. The reason we write this article is because since Mr. Einhorn published his short thesis on JOE, his received critiques from JOE defends. Some of the defenders base their valuation on the DCF analyses.

If you are not familiar to DCF model, go to our DCF Calculator and type in a stock symbol there. Our calculator will automatically search the financial data of the stock, and give you the fair value of the companies based on default settings, which you can modify. The details of how the calculations work can be found in this article: How to calculate intrinsic value using discounted cash flow model?

David Einhorn wrote in his third quarter shareholder letter that there were two defenders; both of them tried to use DCF model to evaluate St. Joe. The first one arrived at a $22 per share value for JOE; the other one came to a value of $50 per share. David Einhorn’s team looked into the DCF model used by the second defender, and changed the gross margin assumption on developed properties from 100% to the historical 35% that JOE achieved before the real estate market collapsed. This revised DCF calculates JOE value to be about $5 per share.

Why DCF model s give such a big difference to the value of JOE? Does that mean DCF model is useless since the valuations differ that much? If we plug JOE into our DCF calculator, the default result is $5.32. But we do have a warning in red in the page which says: “Result may not be accurate due to the low predictability of business.”

In the calculation of the intrinsic values of companies with DCF, there are a lot of assumptions and projections. One projection here is the growth rate of the company in the future years. This will require that operation of the business be highly predictable to make accurate estimations. This is also why we rank the predictability of the companies. DCF calculations can only be applied confidently to the companies that have predictable business.

GuruFocus rated a 1-star to the predictability of the St. Joe business, which means that the business is totally unpredictable. Why is that? Let’s take a look at the revenue of JOE over the past 10 years:

And free cash flow per share:

With a historical revenue and cash flow like this, it is anyone’s guess where the revenue and cash flow will be for St. Joe in the next year. Let alone 5 to 10 years out. Therefore, Using DCF model to evaluate St. Joe’s intrinsic value will not generate results that are dependable.

On the contrary, we will be much more confident if we evaluate Wal-Mart (WMT) using the DCF model. Our default setting gives us an intrinsic value of $70, and the margin of safety of 22%. You may adjust the growth rates and the discount rate there to the values you feel comfortable. Overall we feel much more confident with this calculation.

There are many ways to evaluate companies. DCF is just one of them. It works well with predictable companies. By the way, our studies have found that investing companies with predictable business generates far above average returns at lower risks. For details, please read:

Part I: What worked in the market from 1998-2008? Part I: Predictability Rank

Part II: What worked in the market from 1998-2008? Part II: Role of Valuations

We have developed a number of value screens that search for undervalued stocks among predictable companies. These screens include:

  • Buffett-Munger Screener: Companies with high quality business at undervalued or fair-valued prices. Young Buffett and Munger may like these stocks to hold for long term.

  • Undervalued Companies: Top ranked predictable companies that are undervalued based on DCF model. This model has generated an cumulative gain of 75% since Jan. 2009, while the S&P gained 32% in the same period.

  • DCF Screener: Companies that are undervalued. Free cash flows are used in DCF calculation. Low P/B Companies: Predictable companies that are sold at close to historical low price/book ratios

  • Low P/S Companies: Predictable companies that are sold at close to historical low price/sale ratios

You do need o be a Premium Member to check out those lists. The Premium Member is just $249 a year. We invite you for a FREE 7-day trial.

About the author:

GuruFocus - Stock Picks and Market Insight of Gurus

Rating: 3.7/5 (6 votes)


Jhodges72 - 3 years ago
Good article that touches on an important subject that the new generation of value investors forget. DCF is useless unless the business has a very long history of predictability through bear and bull markets. It is not a good indicator for all businesses nor does is work for a majority of them. John Burr Williams explained this when he came up with the formula but somehow many investors ignore that fact or unaware of it most likely because very few learned how to do a DCF from the original source.
Batalha - 3 years ago
I can't understand the hype with DCF models. There are no barriers to entry in owning an Excel license and learning how to forecast cashflows, which no one can do with accuracy by the way. Thats why Ben Graham shied away from projections and dealing with the future.
Cm1750 premium member - 3 years ago
Batalha - any monkey can plug in numbers. The real value is understanding the durability and certainty of the numbers. In 1999, many MBA-trained tech analysts assumed JDS Uniphase and PMC Sierra could grow EPS 25-30% for the next 10 years.

Jhodges is right - DCF models are generally useful only for stocks where you can, with some moderate level of certainty, determine FCF for the next 5+ years.

However, if you think of a stock as a business, DCF is the only objective way to value it, unless it is an asset play.

If you have no idea what a company may earn in 5 years, why are you buying it? That is the difference between speculation and investing.

What most stock investors don't understand is that stocks are the longest duration asset. Unfortunately, most only look at the next 1-2 years of earnings. Depending on growth, roughly 25-30% of a quality "moat" stock's value is the first 10 years of FCF with the rest being the FCF after 10 years.

WEB knows this - if earnings dip for a couple years, the long-term intrinsic value only changes by only 5%. WEB simply waits until the stock price overshoots (drops 40-50%).
Batalha - 3 years ago
However, if you think of a stock as a business, DCF is the only objective way to value it.I won't waste my time discussing this, you can value your "businesses" the way you want. Actually, I would say it is the least objective way since all the inputs are totally subjective (estimate CAPEX, growth, cost of capital and so forth years into the future). This is something Montier calls the folly of forecasting.[/i]You don't need a DCF to assess durability and certainty of the numbers. It is the other way around, you should be studying the business and the industry.[i]

If you have no idea what a company may earn in 5 years, why are you buying it? That is the difference between speculation and investing.

Ok, this is funny. When you think you can estimate a company's earnings in five years you are speculating and not investing.

Unfortunately, most only look at the next 1-2 years of earnings.

Are you sell side analyst? really?

Superguru - 3 years ago
I found DCF calculator in guru focus site works very well for me if I put growth rate as 0%.

Batalha - 3 years ago
I am sure the math works well because there are smart guys behind GF. However, aren't you bothered that anyone with Internet access (meaning billions of people) can access the site and in 1 minute calculate the "fair value" of a stock?
Superguru - 3 years ago
My point was - I use growth rate for ever as 0% in DCF. If actual growth rate is better than 0% it is a bonus. I did not read it anywhere, just tried it myself and I liked the results.

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