RaplhCramden writes: *Even in the case of investments, DCF is the value, right? But at what discount rate? And who’s prediction of future cash flows are we using? And how do we deal with the FACT that the future is always uncertain (at least until it becomes the past)? Buffett uses relatively low discount rates but demands a margin of safety, which means compared to people who use higher discount rates, Buffett is likely to be a buyer of things with greater future payouts and lesser near term payouts. This is just math, lower discount rates value future earnings much more highly than higher discount rates.*

This is why I have never prepared a discounted cash flow to value a company and neither should you.

Mark me as an apostate.

And, probably, neither does Buffett.

I no longer have the exact quote of a discussion in an annual meeting that occurred several decades ago so I will have to paraphrase, but this gets the gist of it. Buffett was talking about discounted cash flows when Charlie remarked:

Charlie: Warren talks about these discounted cash flows but I have never seen him doing one.

Warren: Well, Charlie, there are some things that are better done in private. Here, have another piece of candy.

For all the reasons mentioned in the first paragraph above, discounted cash flow computations for operating companies are not very actionable. So, I don’t recommend them for valuing a company.

Instead, do what Munger recommends. Create mental models in your head and use them to estimate the value of an asset. For instance, a price-to-earnings ratio is just a short-hand method of computing a discounted cash flow. Run your assumptions of what you think you know, the probability that what you think you know is valid and what you know you don’t know through your models and produce a value range.

Warren and Charlie don’t just use a higher margin of safety when they find themselves capitalizing too much uncertainty in this procedure, they just throw it in the too-hard-pile and go to the next alternative. Repetition and experience will make you good at this.

From my unread treatise on investing, I discuss capitalizing uncertainty as follows: *Using information known or surmised, he capitalizes cash flow numbers. For him, valuing an asset as the net present value of all its future free cash flows seems to be doing something real and determined. While it may appear that he is capitalizing results and numbers, what is really being capitalized are degrees of certainty, probabilities and perceptions. It makes perfect sense to increase our confidence in an asset’s value as its future becomes more certain and predictable and to decrease our confidence in an asset’s value as its future becomes less certain and predictable. So, it also makes as much sense to view the value or price of an asset as capitalized uncertainty as it does to view it as capitalized certainty. It is the same thing, only in reverse.*

However, I do recommend creating a model and fiddling with the assumptions. Create your assumptions: normalized earnings, rate of growth of earnings and discount rate. Then make small changes in these assumptions and watch how much the net present value changes. Small changes can make huge differences when compounding over 50 years. So, when I see the results of computer models projecting, say, the effect of global warming over the next 50 years, I repeat the comments of a young boy in a cartoon. He was at the dinner table with his father and mother and looking at his plate. He remarks: I say it is spinach and I say the hell with it.