Tuesday, September 20, 2005

Terminal Value of Free Cash Flow

I've got to thinking a little bit about financial theory today while talking to my buddy Krish at Wendy's. As I was gobbling down my Jr. Bacon Cheeseburger, Krish brought up an interesting point about the discount rates used in the Terminal Value of an investment: Why is it that the factors affecting the discount rate (cost of capital, cost of debt, beta, etc.) discounted at a lower risk rate even though it is for a longer period of time--thus more possibility for risk and volatility? In other words, shouldn't "forever" be more risky than 5-7 years in the growth assumptions?

I was sitting on the toilet just now--ohh the discoveries we men make while thinking on the toilet, and I got to thinking about that. At the time of the conversation, I couldn't think up anything more intelligible than "it's probably some mystical financial theory that we simply have to adhere to"... but the more I think about it, the more I think I have an answer.

Traditional financial theory defines risk as the probability of short-term loss and volatility swings in the stock price, where-as we "value" managers like to think of risk as the "permenant loss of capital" rather than silly market reactions. The inherent difference between the traditional model and the value model is something that financial modeling has yet to capture. What we are assuming in a traditional discounted cash flow model when looking at the earnings of a firm is that it is going to inherently become more stable as the business grows to a point where it can only grow no more than GDP, at which point its margins stabilize and investors are less subject to "surprises" that would create uncertainty. If its anything the markets hate more--it's uncertainty. Yes, even positive uncertainty where companies earn more than they are supposed to... although that sort of hate primarily comes out as a result of companies not being able to keep up the wonderful "surprise" for many more quarters and fiscal years to come.

Of course, the factor in traditional finance theory that measures this sort of love-hate relationship in stock price volatility is the beta. The beta measures the ups and downs of a stock compared to a basket of other investments like it (most of the time, the beta of a stock is measured by comparing the risk of the security in question with the securities like it in the same industry). When an investment grows faster or slower than that basket, then the beta gets above or below 1, respectively. Now, any student of finance can tell you that a major factor that lowers the discount rate is the beta. In other words, a stock that is less volatile is also less risky. When the performance of a company gets projected into perpetuity, it is assumed that the stock becomes more and more like the larger whole, and thus its beta decreases while reducing the terminal cost of equity (and then WACC).

So in a nutshell, in traditional finance theory, risk is synonymous to volatility. A stock becomes stable as expectations of market expectations become normalized on a forward-going basis (which makes no sense I think--something I'll have to write on later). In exchange for less volatility, a firm is given less growth and shrunken margins to offset the gain in net present value as a result of lower risk.

Now... we value managers don't exactly look at the markets the same way as DCF enthusiasts. We are much too paranoid to feel comfortable projecting earnings on a perpetual basis. While I personally believe that the Present Value of Terminal Free Cash Flow might have some merit in extremely large, indestructible businesses (perhaps... the world economy itself), it certainly doesn't do much in light of reality. Reality is much more cruel, but cruel in a good way. If DCFs worked all the time, then there would be no value left anywhere!

The main difference between value and traditional finance theory is the way we view risk. While traditional finance theory is generally optimistic about growth opportunities and eternal survival of the firm, we value people tend to look at the downside much more. Our risk is not "volatility", our risk is "the permanent loss of capital". Value investing is a combination of relative valuation and fundamental valuation in that we hedge against our risk and expect most of our upside from comparables and tangible book value, not promises of future cash.


That's my story at least. Have you ever gotten a feeling that you teach yourself by talking or writing to yourself? Sometimes you find things you didn't even know you had... Well, I'll leave that for the metaphysicians to figure out :D

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