Discounted free cash flow model

Investing
#1

Hello, Jeremy and sorry for interrupting again. So the last couple of months I come across the DCF, but I have notice that there are 3 variables that depending on their number can provide you a different outcome.
The long term estimated growth
The discount rate
And the terminal value…

Personally, for the LT growth, I used to look some analysts and just take a MOS.
For the discount rate, I used to use the WACC, however, in a video I saw, it suggested to take 8-10% considering that’s the index fund return.
Lastly for the terminal value, I calculate this figure with the perpetuity method, using the avg of the gdp of the last 20 years.

What’s your view about the variables, and the method generally?

Thank again! :slight_smile:

#2

I’m in investment banking so I’ll give my two cents. I’m not entirely sure a DCF would be all that useful for an index fund. A huge assumption of the model is the future FCF of the investments, but the index constituent list is very likely to change quite drastically up until your terminal year, meaning the assumption is near useless.

DCFs are mainly used for valuing private companies ahead of an acquisition. While they can be used for public companies, they are more of a sniff test instead of giving an exact answer of market value since public companies are subject to a swarm of external factors that influence the market value. So taking that idea and multiplying it by 500-1000+ companies in an index fund, the answer you get from the DCF would be nothing more than a guess.

On top of that, Jeremy would probably give the answer that you shouldn’t be worried about models like that at all, given he talks quite a bit about Bogle’s philosophy (simply invest in the whole market). You can just pick one, for example VTSAX, and not have to worry because it’s very well diversified.

1 Like
#3

Hey @Akis!

I love @mornin12’s answer, and I’m sure he has a lot more experience than me since he’s in investment banking.

I’ll just add that discounted free cash flow would be a really simplistic model to try to value the entire stock market. There’s a million other things at play (future innovation, political change, international competition, world pandemics, tax laws, population growth, and fifty million others). There are smart people who hire teams of PhDs and algorithm scientists to write programs to crunch those massive data sets to try to find inefficiencies in the pricing of the market so they can profit. And the companies that do that are competing with other companies that do that, trading thousands of time a second, constantly pricing all of that information into the market.

So from my perspective or your perspective or any one person’s perspective it’s a fool’s errand to try to decided as an individual whether the market is overpriced or not. That’s basically the “efficient market theory”.

So what to do? Ignore the market. Invest early and often. Buy and hold broad market index funds. Keep it simple. This is what will make you the most rich.