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Most deep-value investors look at the balance sheet and P/E multiples when they are hunting for bargains, a strategy taught by the godfather of value investing, Benjamin Graham . However, what strategies like these fail to take into account is cash flow. Glen Greenberg and Donald Yacktman are two respected value investors, both of whom invest not just with asset value in mind but also cash flows. This strategy has yielded results. Greenberg’s fund, Chieftain Capital Management achieved a compounded annual growth rate of 25% from 1984 through 2000, the S&P 500 achieved a return over 16% over the same period. Annual returns through 2010 were 18%. Greenberg uses a DCF model to make his investments but rather than the traditional DCF method, in the style of Graham, Greenberg looks for a margin of safety before investing. This margin of safety is a hurdle/discount rate of 20% for all potential investments when computing the DCF. The rate was lowered to 15% in order to reflect the interest rate environment. (click to enlarge) Adjusted cash flows Meanwhile, Yacktman uses an adjusted cash flow figure to value securities. Yacktman equates the forward rate of return with a company’s free-cash yield . He calculates this yield by computing the FCF, then adds in the cash he believes the business can generate through growth and adjusts for the effect of inflation. That figure is then divided by the stock price. Using this adjusted cash flow figure, Yacktman compares the stock’s forward rate of return with yields on long-term Treasuries. The wider the spread, the deeper the discount and the more attractive the stock is to Yacktman. DCF valuations for forecasting free cash flows: Not clear cut The use of a DCF valuation places less reliance on current market valuations. Instead, it emphasizes the full-information forecasting of free cash flows over a multi-period finite horizon. In comparison, PE models are dependent upon the fact that current earnings measures are good proxies for value, placing emphasis on current, not future value. Moreover, DCF calculations allow for the choice of an appropriate finite horizon, estimation of growth beyond the horizon, and in its standard implementation, estimation of an appropriate WACC and of the value of non-equity claims on the firm. In other words, the valuation is more comprehensive and provides a long-term valuation of the company that it not dependent upon wider market valuations. That being said, there is some evidence to suggest that price targets calculated using a P/E multiple, are more accurate that price targets computed using a DCF analysis. A study entitled “ Does valuation model choice affect target price accuracy? ” found that DCF models are used to justify higher price targets by optimistic analysts. Additionally, a study entitled, Valuation Accuracy and Infinity Horizon Forecast: Empirical Evidence from Europe , published within the Journal of International Financial Management and Accounting 20:2 2009, found that when calculating a DCF forecast, analysis’ tend to factor in an “ideal” long-term growth rate, which is just above the WACC: …Therefore, using this ‘‘ideal’’ growth rate leads to the determination of ‘‘ideal’’ Target Corporation (NYSE: TGT ) prices that respect the long-term steady-state assumptions… Therefore, it’s easy to conclude that if a DCF figure is used to calculate a price target, or identify value opportunities , a suitable, conservative set of figures should be used to compute the DCF in order to prevent optimistic forecasting. Disclosure : None. Scalper1 News
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