In "Margin of Safety,"Â Seth Klarman (Trades, Portfolio) touches upon Net Present Value and its use (or misuse) in valuation methods:
"When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately, future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present-value analysis an imprecise and difficult task.
"Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. A recurring theme in this book is that the future is not predictable, except within fairly wide boundaries.
"There are many investors who make decisions solely on the basis of their own forecasts of future growth. After all, the faster the earnings or cash flow of a business is growing, the greater that business’s present value. Yet several difficulties confront growth-oriented investors. First, such investors frequently demonstrate higher confidence in their ability to predict the future than is warranted. Second, for fast-growing businesses even small differences in one’s estimate of annual growth rates can have a tremendous impact on valuation. Moreover, with so many investors attempting to buy stock in growth companies, the prices of the consensus choices may reach levels unsupported by fundamentals. Since entry to the 'Business Hall of Fame' is frequently through a revolving door, investors may at times be lured into making overly optimistic projections based on temporarily robust results, thereby causing them to overpay for mediocre businesses."
Connecting this with one of Munger’s most famous quotes: “To the man with a hammer everything looks like a nail,” I believe that it is critical as investors to rely upon as many valuation methods as possible, not only NPV. Only companies with franchise value and competitive moats provide a certain degree of certainty to make projections for the future, while many others (the vast majority) are very hard to predict. This is why great investors such as Klarman use very different valuation methods that rely upon tangible values and not only projections for the future.
Warren Buffett and Charlie Munger discuss the NPV method as well:
Buffett: All investing is laying out cash now to get some more back in the future. The concept of "a bird in the hand" came from Aesop in about 600 B.C. He knew a lot, but not that [he lived in] 600 B.C. He couldn’t know everything. The question is, how many birds are in the bush? What is the discount rate? How confident are you that you’ll get the bird? Et cetera. That’s what we do. If you need to use a computer or calculator to figure it out, you shouldn’t buy the investment. Those types of situations fall into the “too-hard” bucket. It should be obvious. It should shout at you, without all the spreadsheets. We see something better.
Munger: Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something.
Buffett: The priesthood has to look like they know more than “a bird in the hand.” You won’t get tenure if you say “a bird in the hand.” False precision is totally crazy. The markets saw it in the Long-Term Capital Management in 1998. It only happens to people with high IQs. The markets of mid-September last year were such that you can’t calculate standard deviations. People’s actions don’t observe laws of math. It’s a terrible mistake to think higher math will take you a long way — you don’t need to understand it, and it may lead you down the wrong path.
What is your preferred valuation technique and why?
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