DCF Valuation Improves Naive Value and Growth Investment Strategies

By Tim Poulus

There are a number of investment strategies out there, but do they make any sense? I think there is a pretty clear answer to that question, but you may not like it.

Let's look at value and growth strategies in particular. Investopedia defines value investing as "The strategy of selecting stocks that trade for less than their intrinsic values." Growth investing is defined as "A strategy whereby an investor seeks out stocks with what they deem good growth potential. In most cases, a growth stock is defined as a company whose earnings are expected to grow at an above-average rate compared to its industry or the overall market." Generally, going by these investment strategies implies doing some form of quantitative analysis. A number or ratio, such as P/E, is calculated and then is statistically checked for any correlation with stock (out)performance.

From a DCF point of view (calculating the value of a stock by adding the present values of all future cash flows) this obviously is total nonsense. Everybody is on the hunt for undervalued assets. That is the whole point of investing, isn't it? And focusing on growth only is just as silly. High growth, combined with a low return on new invested capital (RONIC), is a sure way to value destruction. In other words, high growth only makes sense when combined with a high RONIC.

How do these two views match? Quantitative analysis seems to work; just ask your mutual fund provider. And yet, DCF analysis is just about the only sound strategy (apart from similar strategies such as dividend discount modelling) to do a real valuation job. I believe the answer is in the statistics. I believe this is a very fundamental issue and it explains why there are so many strategies (Dogs of the Dow, etc.), and only one true valuation tool (DCF modeling).

If you have the time and the knowledge, do a DCF model of each individual company you are interested in. This will tell you on an individual basis if a company is undervalued. If you don't have the time and the knowledge, go by statistics and pick out a quantitative strategy that you like.

If you like growth stocks for example, you will be able to select a group of high-growth companies. You need to invest in a pretty large group, because in this analysis you may overlook a company or two that has a very low RONIC and therefore destroys value (which in due time will negatively influence the share performance). If your group is large enough, and assuming there is a positive correlation between growth and performance (which is hard to establish), this will be a winning strategy.

To round off, you may ask: why are all these fund managers so keen on quantitative analysis? They get paid very handsomely and they are trained professionals, so why not do some decent DCF modelling? And if you are an institutional investor, you may ask: why am I outsourcing the investment management process to a manager who is simply doing quantitative analysis? I could easily hire a few "quants" myself and replicate that strategy (and in the process save myself a few hundred basis points).

To that question, I unfortunately do not have the answer.

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