Please disable your Ad Blocker to better interact with this website.

Image Image Image Image Image Image Image Image Image Image

Affluent Christian Investor | October 24, 2017

Scroll to top

Top

No Comments

Academic Financial Models Ignore Human Subjectivity

stack of books

Discounted cash flow (DCF) is the adjustable wrench of modern financial mechanics. Essentially, the analyst forecasts the revenue and costs for several years out and applies an appropriate discount, or interest rate, to calculate what those future dollars are worth today. The process is supposed to provide a hard number for the current worth of the company.

But as many of us recognized in college, there is a lot of room for wiggle in the process. Forecasting revenues and costs is tricky and always based on assumptions. An optimistic analyst might generate a rosy forecast while a pessimist may predict gloom and doom. Usually, analysts just assume the future will look like the past, which is always a dangerous assumption. How many oil analysts saw the recent collapse in oil prices as a result of projecting the past into the future?

Next, analysts have to choose a discount rate, which means they have to forecast interest rates. That is more difficult than predicting revenues and small errors have enormous leverage to ruin analyses. In my book Financial Bull Riding I quoted former American Finance Association president John Cochrane who said in a speech that investor discount rates can change radically:

“Discount rates vary a lot more than we thought. Most of the puzzles and anomalies that we face amount to discount-rate variation we do not understand. Our theoretical controversies are about how discount rates are formed.” (1)

Also, few analysts pay attention to the business cycle that drives the largest changes in revenues, costs and interest rates, and fewer know anything about the ABCT. Not only do profits rise and fall with the amplitude of the cycle, so does risk tolerance on the part of investors that translates to discount rates.

The wizards of finance in academia created DCF in order to make the field more like the hard, math based science of physics. But all they accomplished was to trowel body putty over the ugly subjectivity and apply a coat of paint. However, one professor has peeled back the cracking paint and putty. Aswath Damodaran is Professor of Finance at the Stern School of Business at New York University who teaches classes in corporate finance and valuation, primarily to MBAs. He recently wrote on his blog that

Most people don’t trust DCF valuations, and with good reason. Analysts find ways to hide their bias in their inputs and use complexity to intimidate those who are not as well versed in the valuation game. This may surprise you, but I understand and share that mistrust, especially since I know how easy it is to manipulate numbers to yield almost any value that you want, and to delude yourself, in the process. It is for this reason that I have argued that the test of a valuation is not in the inputs or in the modeling, but in the story underlying the numbers and how well that story holds up to scrutiny.

Damodaran uses Amazon as an example. He arrived at a value of $175/share, but he demonstrates that optimists have arrived at $468 while pessimists went as low as $32. The current stock price is the average of all investors’ expectations about the company. The author concludes that “…the conventional view that intrinsic value, if done right, is timeless is nonsense.” Austrian investors have known this all along and have insisted on a radical application of subjectivism to stock analysis.

Of course the goal of DCF is to help the investor find undervalued stocks and earn more in returns than just investing in a stock index such as the S&P 500. Another way to look at the market is to consider that investors undervalue almost all stocks in the depths of a recession. Profits are low but so is risk tolerance and the discount rate that investors apply to earnings. Then as profits rise and risk tolerance enlarges during the expansion, most stocks become overvalued just before the next crash.

Investors are waking up to the fact that stocks have been overvalued for a while and the economic omens point to a looming recession. So the smart move would be to abandon the stock market for the bond market or cash and wait for the crash, after which investors will be pessimistic and profits will be low so stocks will become undervalued.

Most of the stock market is a great value play in the depths of a recession. Investors don’t even have to be choosy. Just throw money at it. All stocks will rise. But if you want a big boost, choose stocks in the NASDAQ. Companies listed on that exchange tend to be capital goods industries and as we know from the ABCT those companies take the hardest hits in the economic collapse but rebound the most in the recovery.

 

(1) John H.Cochrane, “Presidential Address: Discount Rates,” The Journal of Finance, Vol. LXVI, No. 4, (2011): 1092.

 

Join the conversation!

We have no tolerance for comments containing violence, racism, vulgarity, profanity, all caps, or discourteous behavior. Thank you for partnering with us to maintain a courteous and useful public environment where we can engage in reasonable discourse.

The Affluent Mix

Become An Insider!

Sign up for Affluent Investor's free email newsletter and receive a free copy of our report, "How the Trump Impeachment Crusade Costs you Money ."

Send this to a friend