Value Investing: From Graham to Buffett and Beyond, Edition 2

Let me get straight to the point: no one who actually runs money for a living evaluates growth stocks in the manner prescribed in Chapter 8. The authors pitch their “returns-based” approach as a superior alternative to the DCF, because, as they note, the DCF is sensitive to assumptions and results in a much greater variance of outcomes. The authors contend that, as a result of these variances, calculating the intrinsic value of a rapidly growing company is “impossible”. I find this to be ridiculous. Any attempt at valuation will be subject to a significant degree of error. The idea is not total precision. The DCF is king because it is the literal definition of valuation: a company is worth the sum of its future free cash flows, discounted back to the present. Full stop. The earnings power value approach prescribed earlier in the book IS a DCF -- just one that assumes no growth! Moreover, the earnings power value approach suffers from huge variances depending on the discount rate chosen. Yet the authors are OK endorsing it. Just because a rapidly growing company will result in a wider range of DCF outcomes doesn’t mean that you throw the whole methodology away! Sadly, the proposed replacement methodology is limited to the point of being useless. The authors’ recommended process for analyzing growth stocks is as follows: take a company’s current distributable earnings yield, and add to it your estimate of that company’s long-run organic growth rate. That’s it. The combination of these two things is your expected return. If this return is higher than your cost of capital, then invest in said growth stock! If it is lower, then don’t. The authors then distinguish between “market-based” organic growth, and organic growth driven by “active investment”. I have no qualms with this distinction, and the “active investment” piece speaks to the importance of return on capital exceeding cost of capital. But then there is a needlessly complex further digression highlighting the fact that the organic growth component of the total return equation above doesn’t actually equate to the “real” return that an investor should expect if a company’s market value is above its intrinsic value. There is also an appendix to Chapter 8 that will only serve to confuse readers. The second part of this appendix (or maybe the entire appendix) is written by someone who I'd bet has never managed real money. But now I’m digressing. As I noted, the authors’ method of analyzing growth stocks with their new approach is extremely limited, for several reasons. First, their model cannot handle long-run organic growth rates much higher than 10%, for otherwise the target company would eventually grow to be the size of the entire economy. The authors point this out, but then do nothing about it. So the “returns-based” model does not work for ANY company that is growing quickly (say, 15-25-35% a year for the next 5-7 years). The model also does not work for companies that are losing money or have no retained earnings, or for companies that have dramatically varying year-to-year growth rates. I would say that the above three categories encompass perhaps 90% of all of the interesting growth stocks out there. A DCF approach, of course, works for all three. The authors’ method instead works for only ONE type of growth stock opportunity: the slow-and-steady grower that is profitable. The stalwart-type company. But even for this type of company, the results of the model are nonsensical.

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