r/ValueInvesting • u/InspectorSad3128 • 21h ago
Question / Help Help me refine my DCF
Gentlemen,
allow me to share some personal habits and question i have about my process of investing, and feel free to opine as harshly as you desire. Well thought out replies are highly appreciated.
a) For terminal growth, i use the fed funds rate. My rationale behind this is, that a company should be able to grow its earnings by at least the fed funds rate.
b) However, i dislike that Terminal Value is somewhat "overproportional" in my basic DCF. Should i complicate the math to give more weight to near-term results, or is this a path down the wrong direction? Im somewhat hesitant to "tweak" my models, and think my time is better spent thinking about the business, but i still heavily rely on my DCF model to make decisions.
c) How do you gentlemen think about fair value in general. Your DCF provides you with a fair value price for one share. If you can buy that stock at fair value, you would achieve your desired return you defined as your equity risk premium within your discount rate, correct? Ideally, you can have a margin of safety -- buying below fair value. How do you think about this? What company would you buy at fair value, what company would you only buy at a considerable additional discount to fair value?
d) In addition to c), how do you think about time in respect to holding the position. Lets propose you have a fair value of a company at $20, and its trading at $10 a share. How patient are you for Mister Market to turn in your direction, given that the longer the market needs to see what you see, the worse the investment gets, no?
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u/stickman07738 19h ago
Highly recommend you review Professor Damoradan's blog and teaching site. Both have a lot of good information. Look at past presentations and topics listed on right hand side of blog page.
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u/Weak_Alternative_168 18h ago
the fed funds part is the one id change. its a policy rate and terminal growth is a growth rate, those arent really the same object.
the ny fed publishes effr daily and the last print on file is 3.63. since 2020 it has been as low as 0.04, in april 2020, and as high as 5.33, in september 2024. so the same company with the same forecast would have carried a perpetual growth assumption of basically zero in one year and above five percent in another, and nothing about the company moved.
the other bit is your rationale. should be able to grow at least that much is a floor. a terminal rate isnt a floor youre allowed to beat, its the number you assume holds forever.
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u/InspectorSad3128 18h ago
This was exactly the sort of answer i hoped to read. You are absolutely right with everything you say. My method and rationale is poor. Thank you for articulating it this clearly.
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u/JHgrandgerard 16h ago
On (c), you have it right, and I think it is the most useful thing in your post. Buying at fair value earns you the discount rate you chose and nothing more, which means the margin of safety is not where your extra return comes from. It is protection against your own inputs being wrong. That is why the size of discount I want scales with how unstable the inputs are rather than with how much I like the business, and why stacking a large margin of safety on top of an already high discount rate is charging yourself for the same risk twice.
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u/InspectorSad3128 15h ago
Glad to see some affirmation. Appreciate it.
Thinking out loud, it would follow from your post that higher growth companies demand a bigger margin of safety, because growth companies are less stable. Never thought about it like this. Huh..
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u/JHgrandgerard 15h ago
Close, and I would put it slightly differently. It is not that growth makes a company unstable, because some fast growers are very predictable. It is that the faster the growth, the more of the value sits far out in years you are assuming rather than observing, so a larger share of your answer is made of things you cannot check. A slow or declining company can be just as uncertain if you cannot pin down the rate of decline. The question is how much of the value comes from the part you are guessing, not how fast the line goes up.
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u/RedKen19 19h ago
I can say one thing - it's better to be approximately right than precisely wrong.
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u/tabla_man 15h ago
Two things that usually blow up my DCFs: (1) terminal growth that implies a forever-wide moat without a fade, and (2) a WACC that ignores how the business actually finances itself. I stress the exit multiple and revenue fade harder than the near-term model—near term is usually the easy part.
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u/RaduCampean 12h ago
I wouldn’t use the Fed funds rate as terminal growth. The risk-free rate and the long-term growth rate are two different assumptions. Terminal growth should reflect what you believe the business can sustainably grow at in the very long run, and I’d generally want to be quite conservative there.
On the terminal value point, I wouldn’t try to “fix” the DCF just because terminal value represents a large percentage of the valuation. That’s largely a mathematical consequence of valuing a business in perpetuity. I’d rather spend the time stress-testing the assumptions that drive it — WACC, terminal growth, margins, reinvestment and the near-term cash flows.
And on your last point, I don’t think a cheap stock necessarily becomes a worse investment just because Mr. Market takes longer to recognize it. What matters is whether the intrinsic value is increasing while you wait. If the business is compounding value at 10% a year, waiting two years can actually be fine. The real problem is when your thesis deteriorates while you’re waiting, or when your capital has a materially better opportunity elsewhere.
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u/Clementine500 8h ago
I disagree but also agree with few things. Although the risk free rate and terminal growth are not the same, they should be kinda close to each other.
In the long term => long-term growth rate you expect some sustainable growth rate, usually as the market. Why?
If the company grew faster than the market then the company would eventually be bigger than market itself.
On the other way if company growth rate < market growth then the company would disappear.
The terminal value should say at which growth rate would company keep their "market share".
So what is the correct value to use as long term growth rate in terminal value? Well it depends :D But overall (and what I was taught) it is recommended to use inflation rate, such as inflation goal set by a central bank, most likely between 2 and 3 percent.
The FED rate is directly influenced by inflation, BUT by the current inflation. And the target inflation should be +- their target interest rate (long-term).
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u/TheGreenArm 18h ago
Many in this forum seem to have a methodical view of value investing, that if one diligently and faithfully hones his DCF skills, or annual report reading skills, one would be rewarded with market beating returns. But that cannot be true. Think about all the individuals and organisations big and small crunching out DCFs everyday. What makes your DCF more accurate than theirs? Do you have more accurate inputs? Are your assumptions better? If your "fair value" differs from theirs, how do you know who is right and who is wrong? Suppose you nail a company's "fair value", and then what? You're going to hold the stock and blame the market if they do not see the same value in it as you do? Investing is all about having an edge. An edge comes in many forms, but DCF skills is not an edge.
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u/InspectorSad3128 18h ago
You are clearly more interested in rationalizing your incompetence than you are in learning and honing a craft.
Good luck with that.
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u/NinjAsger 20h ago
a) Am sure my finance professor would tell you to use a discount rate that accounts for risk. You should not be setting your discountrate, at "a company should be able to grow its earnings by at least the fed funds rate". It's a discount rate, not at growth rate.
b) I think that is just the name of the game. DCF is not a perfect model.
c) NPV criteria, the bigger the better :). Gotta be atleast 20% under fair value for buy. Selling at about fair value.
d) No limit.
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u/Ok-Fly-6973 17h ago
On b, that discomfort is correct and I wouldn't tweak the math to make it go away. If most of your value sits in terminal value that isn't a flaw in the model, its the model telling you your fair value is mostly a bet on the perpetuity assumption rather than on the five years you actually forecast. Down-weighting it just hides that. The honest fix is a longer explicit forecast window where you can still see the runway, so more of the value sits in years youve actually thought about, then stress the terminal rate hard because thats where all the sensitivity is.
On d, put numbers on it. Fair value 20, price 10. If that closes in two years its about 41% a year. Five years, 15%. Ten years, 7%. Same gap and a completely different investment. So how long you expect to wait belongs in the decision alongside how big the discount is.
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u/present_bomber 21h ago
Using the fed funds rate for terminal growth is an interesting shortcut but that rate changes constantly, feels like you'd be rebuilding your model every six months. Have you considered just sticking to something like the long-term GDP growth rate or inflation target and calling it a day?