QUALIPORT
When To Forget Buffett

By Maynard Paton (TMFMayn)
February 15, 2005

"In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows - discounted at an appropriate interest rate - that can be expected to occur during the remaining life of the asset."

"Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business."-- Warren Buffett

The Qualiport is based on the investing philosophy of Warren Buffet: Buy great companies at attractive prices and hold for the long term.

Similar to Buffett, the Qualiport only invests in firms that have a sustainable competitive advantage.

Similar to Buffett, the Qualiport aims to hold its shares for years or decades.

But attractive prices? Ah...

Enter the discounted cash flow (DCF), the textbook way of determining the 'intrinsic' value of a company, and one of the most common ways for business-focused investors to emulate Buffett... and lose money.

Despite what Buffett may say (and other talented stock pickers for that matter, e.g. Bill Miller and his efforts with Google (Nasdaq: GOOG)), ordinary shareholders would be better off forgetting about DCFs and sticking with what the great man calls the 'common yardsticks'.

Example

To recap, DCF calculations go something like this:

Year	Cash flow (£m)	Net present value (£m)
0	10.00
1	10.80	10.29
2	11.66	10.58
3	12.60	10.88
4	13.60	11.19
5	14.69	11.51
6	15.87	11.84
7	17.14	12.18
8	18.51	12.53
9	19.99	12.89
10	21.59	13.25
Total		117.14
Year 10 multiple		15
Residual value		198.81
Total value		315.95

The calculation is usually a two-stage process. In the first part, the company's cash flows are projected over a specific timescale and then discounted back to today's money (i.e. their net present value (NPV)).

In the above table, a ten-year growth rate of 8% and a 5% discount rate have been used. Thus for Year 1, the cash flow grows from £10m to £10.80m, which is then discounted by 5% (i.e. divided by 1.05) to get £10.29m. For Year 2, the Year 1 cash flow grows another 8% to £11.66m, which is then divided twice by 1.05 to give £10.58m. The process is repeated up to and including Year 10.

The second part calculates the residual value (i.e. the cash flows of Year 11 onwards) and is determined by placing the Year 10 NPV (i.e. £13.25m) on a suitable multiple (in this case 15). 

The company's overall DCF value is the accumulated NPV of the individually calculated cash flows (Years 1 to 10) plus the residual value (Years 11 onwards). Read more on DCFs.

Problems and pitfalls

So where do Buffett wannabes go wrong with DCFs? These are among the most common problems and pitfalls:

1. Smooth: The future cash flows are invariably based on smooth growth projections. In reality though, companies just do not improve their annual profits in such an orderly fashion. Indeed, most big-name firms have experienced profit declines from time to time, yet precious few DCF forecasts actually incorporate flat or contracting cash flows.

2. Sensitive: Small changes to the assumptions going into a DCF calculation can have a big effect on the end result. For example, in the earlier table, if the 8% growth rate was increased from 8% to 10%, the discount rate was reduced from 5% to 4% and a terminal multiple of 16 rather than 15 was used, the value of the company would rise 22% to £387m.

3. Unknowable: The residual value of the company is based on cash flows to be earned in the years ahead. But unknowable future economic conditions make judging the associated cash flow multiple difficult.

4. Proportion: The residual value often ends up as a substantial proportion of the company's DCF value. In the example, nearly two-thirds of the final value is made up from cash flows produced after Year 10. Note that the further out the company's value lies, the less likely that value actually exists today.

Defence

The following extracts summarise Buffett's defence of DCFs:

"First, we try to stick to businesses we believe we understand. That means they must be relatively simple and stable in character."

"Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying."

"Using precise numbers is, in fact, foolish; working with a range of [DCF] possibilities is the better approach...Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future... reveal that the price quoted is startlingly low in relation to value."

However, all this can be incorporated into more straightforward value measures.

For its part, the Qualiport combines the advantages of the earnings yield (the inverse of the P/E), dividend yield and DCFs by calculating a company's free cash flow yield.

Like Buffett, this portfolio only looks at simple and stable companies. Indeed, steady businesses are always likely to give a more reliable valuation whatever the calculation process.

In terms of a margin of safety, the Qualiport determines a company's free cash flow and (currently) capitalises it at 7.5% to arrive at a 'buy price'. With risk-free gilts offering below 5% at the moment, there's a very good chance that buying a steady business at such a 'buy price' will generate much more cash for shareholders than other investment alternatives.

Furthermore, the 'conservative estimates' Buffett refers to are actually built in to the free cash flow equation. Even if cash flow growth is zero, a high entry yield should still allow shareholders to do relatively well. However, if the cash flows expand, shareholders will do even better. Read more.

In summary, the free cash flow yield may not be perfect, but it's based on today's facts and simple assumptions. Importantly, the measure has helped this Foolish portfolio outrun the market for the last four years. Regardless of what Buffett, John Burr Williams and all the textbooks say, success with shares is all about getting a valuation theory to work in real life.

More: More Big Buffett Mistakes

Portfolio value

Holding	Number of shares	Closing price 14/02/05 (p)	Value (£)
Associated British Ports	681	485.75	3,307.96
Emap	372	887	3,299.64
Halma	1,920	163.75	3,144.00
Johnston Press	1,608	570	9,165.60
London Stock Exchange	2,018	568	11,462.24
Cash			207.07
Total			30,586.51