Friday, Aug 27th 2021

It’s turtles all the way down

Commentary

"It's no use, Mr. James—it's turtles all the way down." — J. R. Ross, Constraints on Variables in Syntax, 1967

You may be wondering what turtles have to do with investing. While not a direct link, the concept of infinite regress applies to the valuation exercise each of us performs when contemplating a potential investment. We would posit that this concept, originating in Hindu mythology, might take another form in the world of finance: it’s DCFs all the way down.

Discounted cash flow (“DCF”) is a method for estimating the value of an investment, by modeling its future cash flows. DCF gets a bad rap, because it heavily relies on its modeler’s assumptions. In other words, an investor can make a DCF model yield any value she wants, by simply tweaking a few key assumptions.

Additionally, DCF model outputs are highly sensitive to a few of these assumptions. This is why investors often use the common refrain, “Garbage in, garbage out.” As a result, many DCF practitioners opt to use “multiples,” which generate valuation estimates based on a company’s fundamental metrics.

The irony is that valuation multiples are simply a DCF in disguise. The mistake that many investors make is that they do not understand the link between their chosen valuation multiples and the underlying driver of value, making this exercise fairly arbitrary.

The intrinsic value of any cash-flow generating asset is the present value of its future cash flows. This applies to real estate, fixed income, art, venture capital: you name it. Accordingly, our objective is to determine how much we would be willing to pay today for the right to receive those cash flows in the future.

Every methodology is, in one way or another, incorporating a view of the value drivers that generate the magnitude, sustainability, and growth of those cash flows. The investment decision is predicated on whether the investor believes the market is, at its current price, underestimating the future cash flow that the asset will generate.

At Titan, we incorporate a variety of different methodologies to form a valuation mosaic based on different scenarios that may play out over time. Our view on the probabilities of each of these scenarios yields a range of values, which allows us to formulate a view on the opportunity’s risk-adjusted forward returns.

We have written about our use of price-implied expectations (“PIE”) analysis in the past, which uses a DCF model by isolating value drivers. In addition to traditional DCFs, we also use the valuation multiples off of which a stock trades. However, the critical point here is that we build up our view of these multiples based on the value drivers mentioned above, which are the determinants of a company’s future cash flows. We incorporate our views on the time value of money and risk into these multiples as well, so that we appropriately underwrite our opportunity cost. By taking this approach, we have a fundamental understanding of why we utilize specific multiples.

It would be fair to say that we view valuation multiples as a short-form DCF, not a shortcut to valuation. So if you would like to know how we at Titan— and all investors, whether they know it or not—value a company before making an investment: it’s DCFs, all the way down.

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