Have you ever listened to an earnings conference call or read a transcript from one of those calls? If you have, you will know that these calls usually have a question and answer session following the prepared remarks, In the Q&A sessions, sell-side analysts that cover these stocks can ask management about anything that is on their mind.
I remember when I started following conference calls, how weird I thought the questions posed were. To me, the questions were unusually specific. It wasn’t until I realized what a sell-side analyst does, that the questions started to make sense. The analysts are simply trying to fish for inputs into their valuation models. They build these models, primarily by using discounted cash flow analysis, to come up with price targets for the stocks that they employed to cover.
The Problem with DCF-Analysis
When you build a Discounted Cash Flow Model, you need to make a bunch of assumptions. By how much will the company grow its revenues in the next few years? How much capital expenditure will it require to maintain that growth? What is the cost of capital? Etc, etc, etc.
DCF models can be very useful and it is imperative for business analysts to understand the possibilities as well as limitations of a DCF analysis. DCF analysis is useful when cash flows are stable and relatively predictable. DCF analysis gets difficult to use if the companies that are being analysed have extremely high growth rates or if they create value by other means than by consuming cash to generate earnings.
Capital Allocation and Balance Sheets
The late Marty Whitman, a legendary value investor, often talked about the Primacy of the Income Account. In his opinion, analysts and other investors where too preoccupied with the income statement and earnings of companies. As a result, the wealth creation that happen through the balance sheet was often overlooked.
I heard a great example of this the other day. I don’t remember which podcast it was, but the interviewee gave the following example:
Imagine if you had run a discounted cash flow analysis of Berkshire Hathaway shortly after Warren Buffett took over as CEO. You would have totally missed the point, since Buffett created value through capital allocation and by utilizing the balance sheet.
A normal DCF model would nerver have captured this.