Saturday, June 10, 2017

Come on Analysts, Do the Analysis

            As a manager of a small hedge fund, I like to compare my views on the valuation of common stocks to those of other analysts in order gain perspective.  This turns out to be a remarkably frustrating exercise.  Here is the problem.  Ultimately, the assessed valuation of a stock depends only on two factors:
1.  The size and timing of the future cash flows (what I call the cash flow profile) the analyst forecasts for the company.
2.  An assessment of the appropriate risk adjusted rate for discounting those forecast cash flows.
Everything else affects assessed valuation only to the extent that it alters those two factors.  So naturally I look for other analysts’ opinions regarding those two factors to compare with my own.  And I virtually never find them.  This is not to say that I can’t find opinions.  The internet is awash in opinions, but those opinions, even in the case of many Wall Street analysts, are almost never translated into the two factors that matter.
            Take Tesla as an example.  Given the celebrity of Elon Musk and the immense run-up in Tesla’s stock price there is an active debate regarding whether the stock is fairly valued.  Unfortunately, that debate is usually couched in terms of vague and incomplete verbal analyses such as, “The Model 3 is a game changer that could support a stock price as high as $500” or “Tesla cannot be valued as a car company because it is an energy technology company.  When seen it this light, its stock price is understandable.”  And on and on.  Lots of words, but no cash flow profile and no discount rate.
            Fortunately, there are exceptions to this rule.  One that stands out is the blog of Prof. Aswath Damodaran.  For the companies he analyzes, Prof. Damodaran not only provides the cash flow profile and the discount rate, along with explanations and calculations showing how he arrived at each, he posts a complete Excel spreadsheet that combines them in a discounted cash flow model that produces his value indicator.  Of course, this careful work does not mean Prof. Damodaran is always right.  Read, for example, his posts on Valeant.  But it does makes it possible for the reader to compare their own opinions with his and to use his spreadsheet to alter the assumptions to assess the impact on valuation. 
            One reaction to analysis such as Prof. Damodaran’s is that forecasting cash flows years into the future is speculative.  Of course it is!  No one ever said valuing stocks is easy.  There is simply no way to avoid the difficulty of long-run cash flow forecasting.  It can be hidden behind vague and incomplete verbal analysis, but that does not make the opinion more accurate or less speculative.  It just makes it more vague and incomplete.
            So I say, Come on analysts, do the analysis.  Follow Prof. Damodaran and let us see the valuation implication of your views.  That requires spelling out their implications for the cash flow profile and the discount rate.  Words without translation into a cash flow profile are pretty much empty words.


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