These are the related articles we have published about this topic:
- Buffett Might Side With Einhorn Over Berkowitz on St. Joe Position
- Poor Old JOE
- Bruce Berkowitz Responds To Einhorn: I Want To Buy You A Box Of Chocolates
- The Long And Short Of The St. Joe Company
- David Einhorn's Short Thesis on St. Joe Company
- David Einhorn's Short Thesis For St. Joe: The Highlight of The Value Investing Congress
- Clash of the Guru Titans – Einhorn vs Berkowitz Over St. Joe (JOE)
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.