When I was 15, I was fascinated with the world of investing. To be honest, all I really cared about was making money on my own. Up to that point in my life, I was -like most of us- completely reliant on my parents. So the thought of being able to double my savings in a relatively short period of time, kept me awake at night. Within a few weeks, I bought my first share in Bank of Ireland (BIR.IR at the time). Although, I literally made a cent on each share (buy price:2.92€ ; sell price:2.93), I was instantly hooked. At that time, I was looking for the perfect formula that can value any business. Fast forward 10 years and I still haven’t found it. What does that mean?
It simply means that there is no formula. I can come up with a perfectly logical valuation for Tesla at $300 and if I change the story I can come up with a valuation of $3,000. Throughout the past ten years I learned that valuation is an art not a science. And that is exactly why you should never believe someone who tells you the value of Tesla is exactly $300 or exactly $600. A good investor will always give you a range. Why?
There are different models that investors use to value a company. Among them are the Discounted Cash Flow model (DCF), Liquidation Value, Multiples Approach, Gordon Growth Model. Essentially all of them are trying to do the same thing: Determine the value. The most widely used and arguably best model is the DCF (some exceptions: Financial Sector Firms and Startups…but that’s for another post). As the name implies, the Discounted Cash Flow model (DCF) tries to estimate the value of an investment based on the present value of its future cash flows (see formula below). Sounds simple, doesn’t it? Well not really.
As you can see we are discounting future cash flows. Yes, we can use advanced regression techniques to try and forecast the future cash flows. But they’ll never be 100% accurate. And that’s just the obvious part! How do you calculate Depreciation (Straight-Line or Declining Balance Depreciation or even another)? How does the business account for Cost of Goods Sold (FIFO, LIFO or other)? How do you calculate the tax rate? (Interesting insight: Companies have 2 books. One for Financial Reporting and one for Tax Reporting. That means that the number you see as a tax expense does not reflect the actual tax payment by the company. If you actually found this interesting, make sure to check out this post to understand more) All of that has a direct impact on the Free Cash Flows. And these are just the questions I thought of while writing this at 1 in the morning. There are even worse scenarios that I did not even want to consider such as: What if a company manipulates its financial statements to mislead investors? (Google Wirecard) And that was just looking at the top half of the equation of the DCF. If you take a look at the denominator, you’ll find an r which stands for the discount rate. But what is the appropriate discount rate? If you studied finance then you know that we usually use the Weighted average cost of capital or WACC. But is there something called a 100% risk-free rate? Which T-Bill do you use (2-years, 10-years, 30-years)? What is the expected return of a stock (CAPM, Fama-French or Carhart four-factor model, or even more factors)? I think you get the big picture.
I guess that does explain some things. In 2019, I read the following article: ‘Goldman Sachs lowers its Tesla price target for the 4th time this year and warns the second half of 2019 could get even worse’. (Here’s the link) At that time Goldman Sachs, arguably the most prestigious investment bank in the world, announced that Tesla is worth $158. Two years later, Tesla stands at over $2,000 (split adjusted). Does that mean the investor was wrong? No. Well, to be honest he probably was. But just to be clear, because Tesla’s price in the market is $2,000 does not necessarily mean that Tesla’s intrinsic value is at $2,000 a share. And what did Goldman Sachs do as Tesla’s share kept soaring? It simply kept pushing its numbers up. According to the latest report from Business Insider, Goldman Sachs has a price target of $295. You might think that’s not that much. If you’ve studied finance or follow the news you’ll know that Tesla had a 5-for-1 stock split a couple of months ago. That means that Goldman Sachs now values Tesla at almost $1,500 (vs. around $150 a year ago). But it’s not just Goldman Sachs. Most of the investment banks kept adjusting their numbers upwards.
My point is not that you should always distrust investment banks or that all of their valuations are flawed. My point is that the world of investing is so complex that it is impossible to say that a stock is worth exactly this amount. That is why you should always use a range instead of exact figures. And most importantly, that is why I believe investing is more of an art than a science!
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