Why Investors Can’t Model Optionality in a DCF | Personal Finance

The portfolio advisor returns 6/15/21

John Rotonti: Dominic Rinaldi asks – Hi, Dominic – “Doesn’t DCF forecast fluctuate so much that it’s only directional, as it can’t take into account new revenue streams and products that don’t exist yet? ? ” Absoutely. You cannot model the optionality in a DCF. It is very difficult to model the optionality in a DCF. However, if you are using your reverse DCF, you do not have to do so. Then I have a side thing to say about it, but if you do a reverse DCF all you do is find out what free cash flow growth rate and how long that free cash flow needs to increase. a number of years to justify today’s share price. This is a much different question from trying to predict future income streams. Trying to come up with assumptions for income streams, operating margins, tax rate, reinvestment, and all those other things. All you do with a reverse DCF is see what growth rate is built into the current stock price and then ask yourself if that is reasonable. That’s # 1. # 2, let’s say you do this reverse DCF and always find that a stock from a company you love, the reverse DCF always says expectations are too high. Then you go to step B, which is to establish a real option pricing model. You can actually use Black-Scholes or some other mathematical option pricing formula to determine how much of the option is factored into today’s share price. Here is a holiday gift for all of you. Michael Mauboussin and Al Rappaport, in their update and review Expectations Invest, they walk you through step by step like you’re a fifth grader, as we were instructed to do earlier today, reverse DCF, and option pricing. Because for some of these companies, Dominic, you can’t just rely on reverse DCF. You must add to this the option pricing model to determine the amount of the option that is built into the price of a stock. Then you ask yourself if this is reasonable. They explain it to you better in the book than any other resource I’ve ever seen. That doesn’t mean it’s easy. There is still a lot of work to be done. You still have to get good at it. It takes time and practice. You have to drill it, you have to drill it, you have to drill it, you have to drill it, you have to drill it for years until you get good at it. But the tool is there to learn how to do it. But yeah, traditional DCFs, I don’t do them because of that. You cannot model the optionality. It’s really difficult.