Thoughts on using the Discounted Cash Flow for Small Caps

Interesting lecture by Professor Aswath Damodaran on intrinsic valuation, where he breaks down the use of the Discounted Cash Flow assumptions in some detail:

Interesting how the students approach DCF and seem to collectively conclude one of the Professor’s portfolio stocks (Twitter!) is overvalued by 1000%+.

It appears that in his investment decisions the Professor can take a contrarian position vis-a-vis his own field of study – where he is counted as among the best. A lesson for all the excel snobs amongst us. Stay humble.

Perhaps this is also because – as his lecture amply demonstrates – the DCF calculation has a lot of moving parts. When you have a lot of moving parts, the risk of error in each moving part gets multiplied to give you an overall risk of error with valuation using DCF.

So it helps to keep it simple while doing valuations. Here’s why I stick to a conventional, back of the envelope calculations like the Price Multiple Model to begin with. I wrote about how an investor can use the Price Multiple Model as a first step valuation, and combine it with other models.

Apart from the complexity, there are other problems with using the DCF for small caps:

  • The Small Cap Risk Premium is hard to determine and there is no sure way to know it exists!
  • Small Caps are subject to cyclical risks, which can lead to wrong factor assumptions in valuation
  • It is hard to predict steady returns with young companies
  • Cost of debt can be hard to calculate for Small Caps that are not investment grade or do not have a debt rating assigned to them

In valuing a Small Cap, it helps to understand intangibles first. It is a case-based approach that takes into account promoter quality, market size, competition, input prices, the balance sheet and scuttlebutt among many other factors.

In short – investing in small caps is a little like Venture Capital investing. Numbers are needed for comfort, before you take that leap across the void of permanent Capital Destruction.

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