A better way to approach stock valuation

When someone gets behind the wheel of a car for a long drive, whether they realise it or not, they are conducting a valuation exercise. This is because their speed is discretionary, and there are costs and benefits to the speed chosen. While speed limits vary, generally speaking, all drivers have the choice to break the speed limit and by how much. On the one hand, some prefer to drive to the speed limit .

Consider a typical discounted cash flow valuation. In a conventional DCF, the analyst will carefully calculate the discount rate, , project future cash flows, , and decide upon a terminal growth rate, . Between these three discretionary components of a DCF model, the analyst largely has the ability to reach any conclusion he or she should desire.

Value judgments are a part of life. Each of us has the option to honk at the slowpoke in the left lane or to go 20 kph over the speed limit because we’re in a hurry. But we also have to be prepared for the consequences. Judgments should have no place in valuation, however. If not, the speedometer on your investment portfolio might be notching much slower gains than you anticipated.

Any investment performance figures quoted herein are for illustrative purposes only and should not be construed as investment advice.

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