Every student of investing is taught the core principle of discounted cash flows. This business principle is also used with intrinsic value. Application of discounted cash flows assists value investors in determining intrinsic value. Academia, major investment brokerages and the majority of investment websites place unquestionable belief in this single formula to equate value for a security. The problem here is that all of them forget or ignore the underlying requirements to use and rely on the outcome of the formula’s solution. In effect, with intrinsic value and the application of discounted cash flows, there is a very narrow set of highly defined parameters whereby this tool is applicable. Used outside of this framework, the result’s reliability quickly drops to nearly zero, like either side of the bell curve.
This article starts out by identifying the highly restrictive requirements to apply discounted cash flows. There are at most 20% of all marketable securities where this formula succeeds in determining intrinsic value. Secondly, the formula is explained to the student and why it is so important to apply it properly. There are several terms and values the user must include in the formula; this section explains them in layman’s words.
The third section below goes into the corporate financial matrix to explain how to determine cash flows. Furthermore, cash flows are just not the past year or years; it is really about future cash flows. How do you equate something in the future?
The final section puts it together when determining intrinsic value. Unlike what others state, intrinsic value is not a definitive value; it is a range. The job of the value investor is to narrow that range to a set of values that are reasonable and effective with generating gains with the value investor’s mindset of ‘buy low, sell high’.
The overall goal of value investing is to buy a security at less than intrinsic value, commonly referred to as creating a margin of safety; then waiting for the market price to recover to a reasonable high and then selling that security. The depiction here illustrates this concept well.
The most popular and improper method to determine intrinsic value is the discounted cash flows method. It was advocated in the book Security Analysis written by Benjamin Graham and David Dodd, the fathers of value investing. However, most so called experts didn’t read the entire book. Graham and Dodd only used this method under certain conditions. The same conditions as explained in the first section below. They strongly encouraged calculating intrinsic value from the assets valuation perspective (balance sheet basis) and not as a function of earnings plus cash adjustments (cash flow).