Bruce Greenwald, author of Value Investing: From Graham to Buffett and Beyond, recently wrote a piece for Columbia’s ideas at work blog in which he discusses how the success of value investing is causing the slow movement away from modern portfolio theory.
The efficient markets/modern portfolio theory is giving way to broader perspectives that incorporate the realities of information asymmetry — the fact that all market participants do not have the same access torelevant information — and deeply ingrained behavioral biases that often dominate actual financial market outcomes.
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In valuation, the discounted cash flow (DCF) approach that business school teach their students has three obvious shortcomings. First, it generally fails to make use of balance sheet information and an approach that ignores potentially significant information will be inferior to an approach that does not. Second, a DCF calculation is a weighted sum of future cash flow estimates. It involves adding good information — the value estimates of near-term cash flows — to bad information — the value estimates of far-future cash flows (typically embodied in a terminal value). The result, as any engineer knows, is that the bad information dominates. A DCF calculation never segregates estimated elements of value by degree of reliability so that reliable elements of value can be separated from unreliable ones. Third, the input assumptions to DCF valuations are parametric — profit margins, revenue levels, growth rates, capital intensities, and costs of capital. There is no easy way to integrate strategic judgments — whether an industry will be viable in the future or whether any firms are likely to enjoy sustainable competitive advantages — into a DCF calculation.
The value approach to valuation — starting with the most reliable information, the balance sheet, to obtain an asset value, then looking at the value of a firm’s present day earnings power, and only then looking at the value of future growth — suffers from none of these deficiencies. It uses all the information (including the balance sheet), organizes that information from most to least reliable (balance sheet to current earnings to future growth in earnings), and is based on a clear relationship between strategic industry judgments and valuation. For example, if a firm does not enjoy competitive advantages in its markets, then it will never sustainably earn above its cost of capital on investments in growth. Under these circumstances growth creates no value and the growth element of value can be ignored no matter how high the growth rate is.
Read the full article here.
Talk to Frank about the future of value investing
The efficient markets/modern portfolio theory is giving way to broader perspectives that incorporate the realities of information asymmetry — the fact that all market participants do not have the same access torelevant information — and deeply ingrained behavioral biases that often dominate actual financial market outcomes.
…
In valuation, the discounted cash flow (DCF) approach that business school teach their students has three obvious shortcomings. First, it generally fails to make use of balance sheet information and an approach that ignores potentially significant information will be inferior to an approach that does not. Second, a DCF calculation is a weighted sum of future cash flow estimates. It involves adding good information — the value estimates of near-term cash flows — to bad information — the value estimates of far-future cash flows (typically embodied in a terminal value). The result, as any engineer knows, is that the bad information dominates. A DCF calculation never segregates estimated elements of value by degree of reliability so that reliable elements of value can be separated from unreliable ones. Third, the input assumptions to DCF valuations are parametric — profit margins, revenue levels, growth rates, capital intensities, and costs of capital. There is no easy way to integrate strategic judgments — whether an industry will be viable in the future or whether any firms are likely to enjoy sustainable competitive advantages — into a DCF calculation.
The value approach to valuation — starting with the most reliable information, the balance sheet, to obtain an asset value, then looking at the value of a firm’s present day earnings power, and only then looking at the value of future growth — suffers from none of these deficiencies. It uses all the information (including the balance sheet), organizes that information from most to least reliable (balance sheet to current earnings to future growth in earnings), and is based on a clear relationship between strategic industry judgments and valuation. For example, if a firm does not enjoy competitive advantages in its markets, then it will never sustainably earn above its cost of capital on investments in growth. Under these circumstances growth creates no value and the growth element of value can be ignored no matter how high the growth rate is.
Read the full article here.
Talk to Frank about the future of value investing
