I came across an article the other day dating back to 2005. The article reviewed the discounted cash flow approach to valuation and provided some examples. It is very interesting to take a look back in time in an effort to gain a better understanding of the investment process. Of course we all know that hindsight is 20 / 20, so I don’t criticize the conclusions of the article.
The article sited Apple and K-Swiss (along with a few others) comparing current price to DCF implications about growth rates and valuation. First, let me say I believe this is a valid exercise with all potential investments. Secondly, I am in no way implying that investors shouldn’t use the DCF approach. With that out of the way - the following assumptions were made back in ‘05;
AAPL (dated 2005)
Stock price date of article = $40
5yr growth est. = 20%
Free Cash Flow = $250million
KSWS
Stock Price date of article = $33
5yr growth est. = 13%
Free Cash Flow = $71.5 million
Article conclusion: margin of safety
AAPL = -136%
KSWS = 56%
Meaning that (based on these assumptions) Apple was vastly overpriced and KSWS was vastly underpriced. Fast forward to today and we see how effective this valuation indicator was. AAPL stock is up over 500%, while KSWS is down over 60% - so much for predictive indicators.
Again, I don’t point this out to marginalize the DCF approach. I use it myself when analyzing potential investments. My point is simply that valuation (however you choose to define it) is only part of the equation within an investment process (yes, a very important part). We must be able to clearly understand the underlying business first and foremost if we are to make any assumptions about its future. We must be careful that we don’t extrapolate recent past trends into the future. As we know, any small alteration to growth rates can radically change a model’s output.
Does this mean that Apple was really undervalued and KSWS was overvalued in ’05? Hard to say – valuing a company is inexact science at best. In defense of the article AAPL certainly seemed pricey at the time of its writing. Shows how much I know.
