Mental Models discussed in this podcast:
- Discount Rates
- Gordon Growth Model
- Discounted Cash Flow Calculation
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You can find out more information by listening to episode 11 of this podcast.
Why DCFs should not be used
- What is a DCF?
- An estimate of all future cash flow (dividends or earnings) and discounted back to the present.
- When you add up these values you get the intrinsic value of a company.
- Gordon Growth Model (perpetual constant growth of a dividend – DCF)
- P = Div (next year’s) / (r-g)
- R = discount rate (10%)
- G = constant growth rate in perpetuity.
- Dividend = $1.64 (Coca-Cola)
- Specific estimates: $27.85 (based on specific year estimates)
- Growth rate: 3% = $23.42 (equivalent to a 7% dividend yield)
- Growth rate: 5% = $32.80 (equivalent to a 5% dividend yield)
- Current price: approx. $46 per share
- Always invert.
- Dividend yield of 3.5% or growth rate of 6.5% in perpetuity.
- Example 2: P/E ratios for growing companies.
- I want to estimate how quickly I can reach a 10% earnings yield.
- I want it to be less than 5 years.
- Without compounding this means a 10% grower you can pay P/E of 15.
- A 20% grower you can pay P/E of 20.
- All of these imply you can sustain that growth for 5 years.
- Why ignore compounding? It’s simpler and conservative.
Discounted Cash Flow calculations and models provide precise estimates of intrinsic value but tend to be flawed. It is much better to improve accuracy by ignoring DCF and using a simple intrinsic value calculation like the Gordon Growth Model.