amazon and apple

Amazon is worth $908 b now, and Apple, $1 t. I am not sure anyone had predicted this five or ten years before. What we should be asking now is whether it is market hype and exuberance, or has any fundamental reasoning behind it.

Value of a cash flow producing asset is the present value of its lifetime cash flows. It is very difficult to estimate how much free cash flows a business will generate during its existence. A business itself changes from its early stage as a newly incorporated, later as a high growth firm, then facing lower growth, and finally as a matured business. These changes take place due to a variety of reasons, first being the nature of business it is operating. A high tech firm will have tremendous challenges for its existence early in life. The technological change is fast-paced. Every business will have to face the macro economic factors and competition. A high profit business will attract competition. Competition will force bring down excess returns. Often, it is the quality of management that will define the course of a business. Sometimes even a poor quality business is steered by an able management, although economics of the business tend to prevail in the long run.

Market price of a publicly traded business is determined by the market forces: demand and supply. Yet, demand will be higher for a high quality business with demonstrated metrics. The market price of a good business is usually higher than that of a bad business. If for instance, the revenues, operating profits, and earnings growth are higher than its competition, the firm will be priced higher. Return on capital and equity tell us how well the capital is being employed in the business. Earnings per share are indicative of how shareholders are rewarded. The higher the growth in eps, the higher the prospects of the business. 

Free cash flows generated by the firm are key to the quality of business. As noted earlier, the value of a firm is the present value of its cash flows. If we cannot estimate perpetual cash flows, at least past cash flows should be able to give us some idea about what they would look like in the next five or ten years. So there must be something to Amazon and Apple to have been priced by the market at trillion dollar levels. Let's find out their past. 

amazon
Amazon had negative free cash flows for 2017. Its operating earnings were $4 b, but Amazon spends huge amounts on research and technology, which are sort of investments for future growth. However these are charged to the income statement when incurred. Similarly it spends on advertising and sales promotions, which tend to benefit the firm over the years. Amazon also has a fair amount of non-cancelable operating leases which operate like debt, but are kept off books. When we make adjustments to the income statement for these costs, we get operating earnings of almost $16 b. Suddenly we find Amazon's operating margins (9%) and return capital (28%) at pretty decent levels. In addition, the advantage Amazon is getting by charging off these costs is that its tax liability becomes lower. 

However, they do not affect cash flows since these are only book adjustments. Amazon's acquisition of Whole Foods for $13 b along with its reinvestment requirements meant negative pretax cash flows of $10 b for 2017. Let's not penalize it because of one year. If we take a look at its previous ten years, we get a cumulative pretax free cash flows to firm of $20 b, or $2 b per year average. Make it previous five years, and we get $2.5 b average. If there was no acquisition in 2017, its pretax fcff would have been $3.5 b for the year. If we deduct its $10 b negative fcff of 2017 from the prior decade's total of $20 b, Amazon as a business has actually had an aggregate (2007-2017) pretax fcff of $10 b. With an effective tax rate of say, 25%, the fcff would be a total of $7.5 b during the past eleven years. 

Yet the market value of Amazon's equity has increased from $42 b (high) and $ 15 b (low) in 2007 to $908 b now. Now to justify its market value, its true cash flow generating ability should be significantly higher than what it is now. Heck, we can't even take its highest fcff so far (2016) of $4.8 b aftertax, for that would mean paying 188 times. Even if we assume 25 times is a fair multiple, market's assessment of Amazon's free cash flows ability will be $36 b. How can Amazon generate $36 b of free cash flows to firm? Alternatively, market must be assuming significantly higher fcff coming in the next decade. That will be possible if Amazon's operating earnings go up, and capital spendings go down. In 2017, its capital spending was $12 b, and the five-year average was $6.3 b.

If we start with $6 b fcff, and project it go grow at 25% annually during the next decade, they will be $55 b in 2027. This is the idea: Revenues $933 b, operating margin 9%, ebit $84 b, tax rate 25%, and $8 b reinvestment will get fcff of $55 b. If we price 2027 fcff at 25 times, and calculate the present value of all cash flows at an expected return of 10%, we will have a value of $632 b for Amazon. But it is worth $908 b now, which means market has different expectations: either the cash flows or fcff multiple will have to be higher. Or perhaps the expected rate of return should change, after all ten year treasuries are currently yielding only 2.823%. Amazon is a high growth business, and growth needs reinvestment, which lowers free cash flows. Isn't the game a bit tricky?

apple
Apple had pretax fcff of $52 b in 2017, and $82 b in 2015. In the last eleven years, it generated fcff of $424 b pretax. With a tax rate of 25%, close to what it has been paying, free cash flows will be over $300 b. Compare that with less than $10 b for Amazon. If we take $60 b pretax, Apple can generate $45 b fcff at least in the near future. Of course, the growth rate for Apple is much lower than that of Amazon's. That is one reason Apple's reinvestment requirements are lower, unless of course, its aspirations for i-Car, et al are going to come alive.

If we start with $45 b fcff, and project it go grow at 7% annually during the next decade, they will be $88 b in 2027. If we price 2027 fcff at 15 times, and calculate the present value of all cash flows at an expected return of 10%, we will have a value of $900 b for Apple's operating business. With net cash of $150 b, we have the market price of $1 t for its equity. The key risk for Apple is its expected growth rate. How long can iPhones shield it?

market
Different cash flows, different growth rates, different set of risks, and yet both Amazon and Apple are priced similar. The markets have reasons that reason cannot understand.

berkshire, apple, and some fiction

Here's an interesting post that talks about Berkshire's acquisition of Apple. I know the work is of some fiction, but still, I don't know why Berkshire should buy 100% of Apple, and not the other way around. Well in fiction, anything is possible, I suppose. As per its latest proxy statement, Vanguard group and Black Rock owned more than 6% each of Apple. After Berkshire's latest quarter filing, it owns about 5% of Apple; and unless it bought more after June 2018, that makes it the third largest owner of Apple. Buffett seems very bullish on Apple, and everyone is going gung-ho after his statement. 

The man doesn't know what to do with his cash. He is adamant about not distributing through dividends or buybacks. What else he could do than stick to some maturing business giving him just about or slightly more than the market returns? 

The post that I referred to says that Berkshire's current cash flows are $45 b and that of Apple are $65 b, and continues to believe that these are going to be their future cash flows too. The author has promptly referenced the workings to Berkshire and Apple here. Well, one reason I don't rely on the third party's numbers are that they can be inaccurate. Even for some fiction action, we need the right numbers, which the post misses. Here's why.

Berkshire's net earnings were $45 b, $24 b, and $24 b respectively for 2017, 2016, and 2015. Earnings aren't free cash flows, remember. Berkshire made some adjustments to its net income, removed the effect of taxes and changes in working capital, and showed operating cash flows of $45 b, $32 b, and $31 b for the three years. Again, operating cash flows aren't free cash flows, remember. For any business, reinvestment is required for two reasons: One, to be where it is in terms of inflation, competition, profitability, and cash. Second, to feed its growth. This is more important. If not for growth prospects, the market will price the business as a no-growth business. If that were so, Berkshire would not be a $500 b business, it would be way less. That means, there has to be some meaningful reinvestment of cash back into the business, which Berkshire has been doing: $11b, $12 b, and $16 b. Then there are acquisitions which are a sort of reinvestment, but may not be required. Berkshire spent $2 b, $31 b, and $4 b in the past three years for acquisitions. It may not spend $30 b for precision castparts like acquisition, but there will be some. To say that Berkshire's free cash flows are $45 b is just hilarious. 

This is what I would do to arrive at Berkshire's free cash flows. The operating income: $25 b, $35 b, and $38 b for the past three years. If you want to include Kraft-Heinz as part of its operations, add another $3 b to its current operating profits. Berkshire had one-off gains in 2017 due to changes in the recent tax laws. Let's just forget it for the moment, and assume an effective tax liability of 25%. That brings down aftertax operating earnings to $20 b, $26 b, and $28 b. Depreciation ($9 b, $8 b, and $7 b) is a non-cash charge, and therefore gets added to the earnings. But then as we noted earlier, Berkshire's capital spending requirements are imperative to its future growth; so they get reduced from earnings. Now we have the adjusted numbers: $18 b, $22 b, and $20 b. We need to make two more adjustments before we arrive at the free cash flows of the operating business. Berkshire took $25 b as positive cash due to its losses and loss adjustment expenses for 2017. I see it as exceptional because they were not as high in the previous years. They were like $4 b, $2 b, $7 b, and $0.5 b for 2016, 2015, 2014, and 2013. In the absence of linearity, we are left to be judgmental. I would take $2 b positive adjustment change in non-cash working capital, which works out be average of the previous few years. I would also keep $2 b as average spending on acquisitions, for these may be required to feed some of the operating businesses. 

In summary, for Berkshire, we have operating earnings adjusted for taxes, depreciation, capital spending, acquisitions, and working capital before we arrive at the free cash flows for the business. And they work out to $18 b, $22 b, and $20 b for the years 2017, 2016, and 2015 respectively. More importantly, they are not $45 b as the aforementioned post likes to have.

For a normal business, to arrive at the free cash flows to equity, we should be adding income from cash and marketable securities, and deduct finance costs, and net cash from debt financing. But Berkshire isn't a normal business, and its income statement reporting is also somewhat not normal, may be because of its insurance business element. Because of this, I have already included income from investments in the earnings, but have not deducted finance costs. Berkshire's finance costs for 2017 were $5 b. There it goes from our free cash flows to firm of $18 b calculated earlier. Nevertheless, I would like to keep financing cash (interest, new debt, debt repayments) separately, and use fcff rather than fcfe. Ttherefore, my estimate of Berkshire's fcff is what I looked at before: $18 b, $22 b, and $20 b. Let's keep it that way.

I can also argue that Apple's free cash flows capacity is not $65 b, but $45 b. Now we need to have another look at Berkshire's fiction of Apple acquisition. Can a $20 b free cash generating firm, and having $200 b of cash, $123 b of investments, and $102 b of debt, be in a position to buy Apple? In fact, Berkshire also has some operating lease debt of $7 b not included in its books. 

Buffett may be exuberant, and he has reasons for that: He is looking for growth somewhere. Even a teeny bit more than that of market's is good for him. That does not mean he will be in a position to buy the whole of a business having $250 b cash, $130 debt (including leases and non-cancellable purchase obligations), and having an equity market value of $1 t. Buffett must have mentioned it on a lighter note, let's just take it that way. In fact, Apple could look to buy 100% of Berkshire if it wants some growth. Again I am talking fiction, am I not? Fun is good.

diverisifcation, or just geico, is the question

Someone asked me about the number of stocks good enough to own. That's about diversification. There isn't one good answer to it, for as low as just one stock can lead you to riches if the knowledge about the business behind it is good enough. But that will also expose you to some extreme concentration. If you owned more than say, 15 stocks, you will likely have diversification problems. If you cannot remember the names of businesses you own without referring to your books, you have some diversification issues to deal with. These are just general thoughts. There aren't right or wrong answers here though. There are more ways to make money than you and I can think of.

Graham-Newman Corporation had always owned more than some hundred securities, which were well diversified. The hedge fund managed by Ben Graham did quite well during the post-depression period comfortably beating the market. Graham published the Intelligent Investor in 1949, but a year before that in 1948, he bought 50% ownership in Geico for $712,500. This represented 20% of the fund's assets, which was remarkable considering the manager's mandate regarding adequate diversification.

The investment itself and the fund assets may not look large at about $7.5 m and $37.5 m at today's values. But a large part of the fund was exposed to the prospects of just one business. Ironically, even when the SEC had issues with the fund owning the insurance firm, Graham did not back out. He felt the price was moderate in relation to earnings and assets. Geico wasn't even a bargain for the master investor who researched for undervalued securities with adequate of margin of safety. Even when the stock was later priced much higher than what Graham felt as a fair value, he did not sell it, for he considered Geico, a family business. This was unusual for Graham to have developed a biased fondness to the stock. Heck, who cared? The stock did very well.

By 1972 though the value of that investment had reached $400 m which had to be distributed to the fund's shareholders as per the directives of the SEC. Nevertheless, there was an important result of this investment by Graham's own admission: The aggregate profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners' specialized fields, involving much investigation, endless pondering, and countless individual decisions. More importantly, he also acknowledged the role of luck: One lucky break, or one extremely shrewd decision - can we tell them apart? - may count for more than a lifetime of journeyman efforts.

In 1951 Warren Buffett as a 21 year old put 50% of his capital at the time in Geico. By next year he made a cool profit of about $5,000: 350 shares bought at $29, and sold at $43. The cost of investment in today's value is nearly $100,000; Buffett was an able investor early in age. Later as the stock fell to $2 in 1976, he again started buying Geico, and by 1985 had raised the ownership to 50%, and by 1995, Geico became Berkshire Hathaway's 100% subsidiary. The maximum courage he demonstrated was in 1976 when the business wasn't doing well at all and was facing huge trouble in terms of growth and survival.

The thing is if your work is investing, and even if you are shrewd or lucky enough to put your entire cash into one or two businesses, and they do very well to take care of your life's money needs, there is another problem that you will have to tackle: What will you do while your cash is passively betting on these two extraordinary businesses? You gotta have another exciting calling to spend your life. Being a couch potato is fine if you find it a lifelong fun, with nothing else to do. For the rest, there has to be something else.

A five to ten stocks investment portfolio is what I like and find exciting. That keeps me busy at work, and also entails me to have fun.

dollar or rupee, where to invest

The Indian rupee has touched Rs.70 per dollar now. The price of everything is determined by its demand and supply. It's that simple. If the demand for dollar goes up in relation to rupee, obviously the dollar's price relative to the rupee will increase. There may be a number of reasons why demand is up or down: trade requirements, inflation, interest rates, or even speculation, or just anything for that matter. But the basic premise does not change. Currently there are more buyers of dollar than rupee. Until the equation changes, the exchange rates will be in favor of the dollar.

But then, the equation has not changed for a long time. By the end of 1990, a dollar cost Rs.18.136. By the time 2017 ended, rupee was down about 71.59%; that's what happened in a 27-year period. To put into perspective, Rs.1000 bought $55.14 worth of products and services at the beginning of 1991; and by the beginning of 2018, it could buy only $15.66 worth. If you are one of those who needs dollars periodically to make payments, you have been in trouble. Reverse is true for those who have been receiving dollars for their services.

The rupee has always been beaten by the dollar. By 1995, its loss was 12.40% on an annual basis since 1990; by 2000, it lost 9.02% per annum; by 2005, 5.88%. Its first notable gain (5.10%) against the dollar for the year was in 2003 when it ended Rs.45.625 per dollar. The next year it gained 5.49% again. As 2007 ended, rupee seemed to be in demand closing at Rs.39.405. It was to however see its biggest fall in a year (18.95%) in 2008 at Rs.48.620. The rupee gained somewhat in the subsequent two years. But more than 15% loss in 2011 and more than 11% loss in 2013 brought the rupee to Rs.61.810. In fact, it gained 6.45% in 2017 only to stare at Rs.70 per dollar now.

Although the year on year changes have been erratic and non-linear, it is fair to say that the rupee gets rated downward in relation to the dollar every year by about 5% over long term. That's the cost of being in rupees as opposed to dollars. Inflation is a real tax on currencies. If the purchasing power of rupee goes down 7% each year because of inflation, and that of dollar by 2%, the relative prices of both currencies should reflect that. If they don't, eventually market forces will ensure that. That's what has been happening for the last two and half decades at least; remember the rupee's fall of over 70%. 

If an investor put money in the Nifty-50 as 1991 began, the annual return over 27 years would be 13.64%. If the investor was based out of India, that should suffice. But if someone based out of the US had invested when the exchange rate was Rs.18.136, the annual return would be 8.46% because of the 2017 closing rate of Rs.63.840. A similar investment for the US investor in the S&P-500 earned 8.06% over the 27-year period. If an Indian investor was able to invest rupees in the US index, the return would be 13.21% adjusted to the exchange rates. It is probably fair because the investment return largely makes up for the difference in inflation rates in both the countries.

In short, the US (dollars) investor in India should look at making at least 5% more than what is possible back home. And the Indian (rupee) investor in the US should be ok if the returns from the US investments are 5% lower than what is possible in India. That is an even-steven situation. The interest rate parity explains it. However, investors cross boundaries and take additional risks to make more than what is otherwise possible. Therefore, I think factoring in a 5% depreciation of the rupee against the dollar on a yearly basis is helpful. Of course over shorter periods anything is possible, but it is not possible to predict it.

For rupee to strengthen against dollar, Indians will have to collect more dollars (through trade and business) than they have to pay. The net dollars collected are then sold to convert into rupees increasing its demand. Reducing inflation differential will be useful in the long term. Two possible, but not plausible, scenarios are reducing gold and oil imports. The first one is a habitual problem, and the second one is not controllable. So 5% is what I am willing to go with. 

tcs, and its glory

TCS is planning a buyback worth Rs.160 b at a price of Rs.2,100 per share. That should reduce its March 2018 cash to Rs.272 b. Never mind the current cash position, it's only 3 months since after all. Let's work with the March 2018 numbers. It had 1914 m shares then; subsequently in May 2018, it carried out a 1:1 bonus; so there are 3828 m shares outstanding as of now. After the buyback they will be 76.1 m lower. Is Rs.2,100 a fair price for the stock? There are two things necessary to do a buyback: First, it should have excess cash which TCS has in plenty. Second, the price should be lower than its intrinsic value. If not, the selling shareholders will benefit. That is a conundrum for both the managers and shareholders. What the heck is the value per share of the stock? The market price is about Rs.2,000 now. 

TCS had revenues of Rs.1,231 b in 2018. More than 80% of that comes from Americas and Europe. It serves the services sector much more than the manufacturing sector, with leadership in banking, finance and insurance space.

The revenues increased by 14% and 18% annually in the past 5 and 10 years respectively. However, it did clock its lowest revenue growth in a decade at 4.36% last year. Is that any indication? In fact in 2017 also the revenue growth was lower than double digits. 

TCS does not spend much on research and development. It is about 1% of revenues. I prefer not to make any adjustment to its operating profits. Operating margins are pretty stable at around 25%. Earnings per share was Rs.25.68 (2008), Rs.70.99 (2013), and Rs.134.91 (2018); these are all pre-bonus numbers. It had a double digit growth in the past 5- and 10-year periods. Yet, the growth was as low as 1.12% for 2018. This was despite a buyback of 56 b shares at a pre-bonus price of Rs.2,850 per share in May 2017. Since then the stock has gained 40% to date; the buyback turned out to be a bargain for the existing shareholders. Net margins have also been stable at around 20%. Return on capital and equity have remained very healthy. It had a book debt of Rs.2.5 b, and lease debt of Rs.37 b. Yeah, TCS has some non-cancellable operating leases. 

How much can its EPS grow in the next 10 years, for instance? Adjusted to May 2018 bonus, if it grows at 10%, it will be Rs.175 per share after a decade. At a multiple of 25 as a reward for growth, the market price will be Rs.4,375, giving an annual return of 7.25% for the period. Make it 9.50% including dividends. Are we happy with that rate? What are the alternative opportunities available? What if the growth rate is 7%? Well, the return also will be lower at about 4.25% including dividends, assuming a lower multiple of 20 for lower growth. That's the risk all equities carry. 

Historically TCS has been priced at higher price-to-fcff multiples. Let's assume that a multiple of 20 is fair as it stands today as an aging information technology services business, and that its average free cash flows annually are Rs.200 b. If these free cash flows grow at 10% annually over the next decade, our expected return from the stock will be about 7.55% for the period.

I also did a dcf valuation for the business. At its current price, the implied rate of return for the stock is 7.36% based on my assumptions regarding growth rates and reinvestment of course. 

If our expected returns are higher than 10%, we need to expect higher growth rates in revenues, earnings, and cash flows from the business. Is that possible? TCS managers have found Rs.2,100 as a fair price for the share buyback; may be they know more about its story than we do. 

TCS was available at Rs.709 b in 2008, at its low price. In 2013, the low price for the business was Rs.2,082 b. Today it is priced more than Rs.7,500 b. That's hypothetical because Tata Sons owns more than 70% of the business; and it ain't going to sell. In addition, TCS paid out a total of Rs.663 b in cash dividends in the last decade. Of course it has been a super business. Whether TCS and its peers in India are aging IT services businesses which have matured already, or there is more innovation and growth in store is the question before the analysts.

portfolio set up, and strategies

I usually don't offer any advice unless asked for. I am careful about the fact that much free advice is just that, and pretty useless. Sometimes I use the word you in my posts, but generally, it denotes more of I or we than you. Much of this blogpost is a collection of my thought process, and how I like to conduct myself rather than telling others about what to do. If I have not succeeded in conveying that it is probably a shortcoming, which I hope to correct in the coming times. In short, I really don't care what others do, just as I know that others don't care what I do. It is like as someone said: don't tell your problems to others because the half don't care and the rest are happy that you have them. Such is the world. It is better to be the master of your fate and captain of your soul, yourself. Be the Invictus.

Here's how I set up my investment portfolio. Needless to say it again, yet, I don't care what others do for themselves. I have a three-layered structure. 

The first one consists of high quality stocks bought at reasonable prices compared to their sustainable long term competitive advantages. I buy them for keeps irrespective of their current prices, top or low. The intention is to be a part owner of those businesses and enjoy the ride with them. The expectation is to earn decent compounding returns over a long period of time. The portfolio consists of 5-10 stocks. I don't believe in extreme diversification. Obviously, there isn't much of thrill or fun in this, as it should be. When I seek it, I go to my third portfolio. And obviously, a large portion of my cash is allocated here. 

The second one is about investing for not very long. The stocks that I buy are meant for any time from a year or two. The cap is three years. There are plenty of stocks that will be available at prices that are considered to be a bargain, and are likely to yield more than market returns in a short period of time. This is to take advantage of market's folly and profit from it. Although there is no limit to the number of stocks that I buy, usually I restrict to less than 10 stocks. The number is more likely to be 5 than 10. These are not meant for long term, and therefore are not necessarily of high quality stocks. Nevertheless, because by nature I am more conservative, I tend to pick only those stocks which are not low quality businesses. I also avoid those which have disproportionate debts. There are some sectors that I avoid no matter how attractive the prices look to me. A year is a long term and a three-year period is a very long term for the most in the market, and this itself offers opportunities to me to earn reasonable returns over the period. Research for this keeps me busy and excited. Because of the number of stocks that represent this portfolio, there aren't much of buys and sells, only just enough of them to align with the objective. 

The third portfolio is more of fun and excitement. This involves buying stocks meant to sell them in less than a year. It is not possible to do this all the time, but mostly the cap is a year. The sells can happen in a few days to a few months. A few months is an apt period for this activity. Needless to say, I am not a day trader. I don't look at charts, etc. because I find them boring. The idea here is to make money when the markets are volatile. The idea is to have some fun and games as the markets unfold by the day. Usually I get to pay my bills through this, although nothing is guaranteed. No free lunches all the time, remember. And obviously, a very small portion of my stash is allocated to this. 

Frankly, I have too much of leisure. Despite running a three-pronged portfolio, the amount of transactions that I do is very limited. There aren't buys or sells for days together. There aren't meaningful buys for months together. I value businesses that I never mean to buy for instance, just for fun. It gives me an idea as to how businesses should not be run. The leisure time is meant for anything: reading up on the businesses (research), business books, story books, or going out, or spending the day in praise of idleness, or anything for that matter. Dealing with greed, fear, and envy in a manner that should be has been very helpful for me in having fun. 

I find markets exciting is an understatement. I consider myself a student of business, finance, and markets. An earnest student of this exciting game. I am also aware that much of the investment success, or even life's success is attributed to some luck, without which we render ourselves to be both arrogant and useless. Some humility is good. 

reliable valuation is a farce

Predicting the future is a waste of time

Someone said he was not good at prediction, especially the future. Well it applies to everyone, but not many accept it. That is why soothsayers and fortunetellers flourish. If there is demand, supply is automatic and natural. Nevertheless, investing in stocks requires knowing the future. We are talking about investors, not speculators and traders. Since a stock represents its underlying business, knowing the value of that business before making investments is imperative. 

Intrinsic value of a business

The value of a business is essentially the present value of all of its future cash flows using an appropriate discount rate. That may sound profound because it is. If it were straightforward, a worksheet would make people rich. All you require as input data are the cash flows until liquidation of the business and a discount rate to bring them to the present value. 

To make life a little simpler, we break down the lifespan of the business in two parts: One, a selected period comprising the number of years we expect the business to grow and to be able to estimate its cash flows, and Two, the stable period representing the rest of the lifespan. The common periods being used are: 10 years of business growth, and then a stable-growth period. Now we need inputs relating to the growth rates over 10 years and then a stable growth rate. The whole exercise involves estimating revenues, operating margins, and reinvestment. It requires estimating debt, including off-balance sheet. We may even have to estimate possible equity dilutions, and this can get complicated by the grant of stock options. Any claims against the business from the non-equity holders will have to be considered as well. There are more. 

Even when we want to keep things simple, we require at least a few estimates to arrive at the free cash flows: 1) The expected growth rate in revenues for the next 10 years; 2) The expected operating margins, and therefore operating profits over the next 10 years; 3) The expected reinvestment required to sustain the expected growth; 4) A stable growth rate assuming that the business will grow at a constant rate perpetually; 5) The stable period operating margins, profits, and reinvestment. 

The past growth rates and near-future prospects usually are a guide for estimating the future growth rates and operating margins. A cap on the business growth considering the whole economy is helpful in estimating the stable period growth. The internal consistency in our calculations helps us estimate the reinvestment required. Yet, these are estimates, and all estimates miss actual numbers reported by the business. Analysts then blame the managers for not meeting their estimates; and that calls for an ugh. Investors are left either amused or let down by their own estimates turning turkeys. 

It's a farce

I have been valuing businesses for a long time, and I know what it means to use a discounted cash flow approach to value a stock. But then I also know its demerits. When every single estimate used is going to miss the actual, is there a point in doing the whole calculation? And what's this stable-period business business? For a high-growth business, like Amazon, most of the value comes from the stable period, which may not be a true reflection of its forthcoming proceedings. We falter when we use a constant growth period after say, 10 years and the business moves on to grow at different rates over say, the subsequent 10-year period. For a mature business, the other way around is true, where most of the value will be front loaded, and the perpetual-growth value will be a small portion of it. But who knows when businesses such as Maruti Suzuki, Bharti Airtel, and Kotak bank, for instance, will become mature? We cannot use say, 4% perpetual growth rate after 10 years, if they can grow significantly higher in the 11-to-20 year period. Die-hard fans of DCF claim that the present value of the second decade cash flow will not be much to impact the total intrinsic value of the business. They are wrong because it will, if the growth rates are significantly different. They also advice using a second growth period, say the second decade, if required. Again as someone said, is there a perverse human behavior that likes to make simple things complicated?

Analysts and investors dealing with the multiples such as earnings, book, and revenues are cheating themselves if they thought they are valuing the business. They are not because the multiples are a pricing mechanism. They might come in handy to them, but these multiples if used intrinsically should yield the response similar to a DCF valuation, because after all, each multiple is reflective of the cash flows, growth rate, and the risks of the business. 

The hack

What's it then, can we not value a business at all? Where's the alternative? The first thing I have found is that dealing with perpetuity is both a pain and foolish. So I chuck the assumption of the stable growth period. Now we have only a selected future period for which estimates will have to be made. We still need cash flows and growth rates for that period. Because these cash flows aren't the entire stash of the business, we cannot use DCF to value the business. We will have to pick a pricing tool to estimate the price of the business. But central to this theme is I don't want to use my own estimate of the price. How do I know for sure that the business is worth 25 times earnings or 3 times book, for instance? 

Instead I want the market to tell me what the business is worth as per its own estimates and pricing. My life then becomes much easier. All I have to do is deal with the market in terms of buy, sell, or no action. Here's the vital piece of the model: The market gives me the clue as to whether the business is priced significantly higher, significantly lower, or reasonably priced. I will know it estimating the market implied growth rates in earnings, book value, or cash flows. Earnings are more important than revenues; but earnings can be manipulated. Cash flows are much better than earnings. Accounting rules can trick earnings, but not cash flows. Here's another point: I will never know the actual intrinsic value of the business. But thank heavens, I don't need to know it. All I need is the market's estimates during my investment period, and my own knowledge about the business. The key is to assess whether the absurdity in pricing is apparent. It is not important to know by how much because that is not possible without having an accurate value for the business. As long as the price appears to be absurd and out of sync with the business fundamentals, there's a case for either a buy or a sell decision.

I believe that wherever humans are involved we will find some sort of inefficiencies, which often take to some absurd levels. The financial markets aren't an exception; they happen all the time there, but at different points. The overall market may be reasonably priced, but a specific stock may be significantly underpriced, for instance. For a careful investor, observing this game from a distance gives opportunities for profit. All the investor has to do is to play the game by own terms, not giving in to the market's stunts. The game is more behavioral than mathematical. 

Apple reached $1 t market value yesterday. Since this is a fact, the potential investor has to find out what's in store for him in future. Apple's annual numbers are a couple of months away. But we know that it generated average free cash flows to firm of $45 b during the past (2013-2017) five years. It also had net cash of $153 b as of September 2017, not very different from what it reported for June 2018. The free cash flows peaked in 2015 to $66 b; for 2017, they were $41 b. We don't have to estimate the cash flows during each of the next say, 5 years. Let markets do that work. We know that the growth rates have been erratic in the past. However based on the current pricing, the markets are telling us that if these cash flows grow 5% annually, and if they are priced 18 times at the 5th year, we can make 10% annually over the 5-year period. The markets have brought their estimates of the 5-year cash flows to the present value using a discount rate of 10%. Now we have some clue regarding our decision as to whether to buy, sell, or ignore the market offering. This, I have understood, gives me the comfort in making decisions rather than simply input the numbers on the worksheet and bring out the present value. We will have to assess whether the growth rates are significantly higher or lower than that are sustainable for Apple as a business. It is still heavily dependent upon iPhones; none of its new products have been that encouraging. There is a fair amount of judgment involved in making the decision, but at least here we are challenging the market's estimates rather than making our own. We also have to check if 10% returns sound interesting to us. We can also juggle around with the growth rates and pricing multiple to arrive at the current market value of the business. It's not difficult to catch insanity in the market's assumptions. 

By the way, I still love doing that DCF stuff, why I valued Apple, Facebook, and Alphabet only yesterday. It is fun, and just that; I love it. I don't make any investment decisions based on DCF anymore, although if done accurately, DCF is the only model to calculate the intrinsic value of a cash-flow-throwing asset. But then the catch is we cannot do it accurately. Why lie to ourselves then?

That does not stop business managers and their investment advisors in pulling out complex worksheets and fancy presentations to compensate for the hollow math. That is how the mergers and acquisitions take place anyway. As I said when there is demand, supply will find its place. Managers look grand, and advisors make money on most acquisitions. The joke is, if you keep lying to yourself about something, you will eventually start believing it. Repetition works like magic in here too. My advice though is that don't try it.