What is 'Valuation?'

The theoretical value of a company is perfectly described as the discounted present value of all future cash flows. Back in 1934, when Graham and Dodd published the first edition of Security Analysis, when bonds were investing and stocks were speculation, valuing bonds was fairly easy, all the inputs to the DCF formula were specified by the bond itself, interest rate, coupons, and expiration date. All that one had to figure out was whether the business had the revenue to cover the coupons and to return the capital at expiration.

The problem with using DCF with stocks is that all the inputs are pure guesswork. What will be the interest rate in 2025? What revenue and profits will the company have in 2030? There is no better known formula than DCF but if the inputs are not known then analysts will play it safe and raise the interest rate and lower the revenue and profits which leads to understating the value of the company. It might sort of work with low or no growth companies but it’s GIGO - Garbage In Garbage Out - with growth companies.

That does not mean that ‘valuation’ is not important but we need better tools to figure it out. My suggestion is to get acquainted with Complex Systems and other more modern concepts than DCF which is no longer a useful tool for calculating future value.

Denny Schlesinger

I have a copy of the 1934 edition and have read it multiple times

Security Analysis (book) - Wikipedia.


I think valuation is highly subjective.
As you pointed out, back then valuing bonds was just a matter of testing their sensitivity to fluctuations in interest rates, all the other inputs were known. But in the 1930s you’d only have government bonds and very secure corporate bonds issued by railroads or utilities. No high yield bonds. So bankruptcy risk (which entails having a view on the business and on the value of the equity) was not really a prime factor. So, very little subjectivity there.
When doing a DCF for the value of the equity, there’s high subjectivity involved, primarily in the choice of the discount rate. The Capital Asset Pricing Model fed us all with that bs of the weighted average cost of capital. They made us think that every company had a unique discount rate for its cash flows, no matter the risk tolerance of whoever intends to buy those cash flows. To this extent, the discount rate to use should really be our personal threshold rate of return, below which we don’t even sit at the table. And of course such rate also depends on the risk of the cash flows being discounted. Personally, even when rates were at or near zero, I’ve always used a threshold rate of at least 15% for high growth companies.
I think that a universal, objective method does not exist.
At the end of the day, sure, valuation matters at the extremes, but stocks don’t go up because they’re undervalued. Stocks go up because people buy them. And people buy them because they like their underlying businesses.
So I guess my view on this is that a holistic approach à la Saul is probably the best way to go about evaluating whether something’s worth investing in. More like a box-checking exercise that makes you sure everything is in its right place.


I started replying - I have quite a bit to say on this topic (and it is a worthy and probably very long and tedious debate) - but decided to just note that this is probably way OT for this board.