“People’s thought process is too tied to conventions or analogies to previous experiences. It’s rare for people to try to think about something based on first principles. They’ll say, “We’re doing it because that’s how it’s always been done.” Or they won’t do it because, “Well, no one’s ever done that before, so it must be no good.” But that’s just a ridiculous one Way of thinking. You have to build the argument from the ground up – “starting from first principles” is the term utilized in physics. You take a look at the fundamentals and construct your argument from that, and you then see whether you come to a conclusion that works or not, and whether or not it may be different from what people have done up to now .” — Elon Musk
I could stay awake. I knew something was incorrect. The numbers just didn’t make sense. For years, pipeline energy analysts looked as if it would adjust their valuation models for pipeline master limited partnership (MLP) stocks to elucidate what was happening to the value.
But why? Why should the models be adapted for one group of corporations and never for one more? Cash is money and value is the measure of how much money flows out and in of an organization. There are not any different rules for various corporations. The assessment is universal.
Analysts valued MLPs using the price-to-distributable money flow valuation multiple and the distribution yield, which is the distribution per share divided by the share price. But growth investments support distributable money flow and increase it in the longer term. The pipeline’s MLP valuation calculations ignored this. Why should pipeline MLPs get a free pass on shareholder capital invested in growth projects while other corporations didn’t?
How unbalanced were the MLP evaluation processes? Meta Platforms, formerly Facebook, is issued not less than $10 billion this yr in its Metaverse division, Facebook Reality Labs, to develop virtual and augmented reality applications. Imagine ignoring these billions in growth investments and still recognizing Meta for the free money flow growth related to these expenses. That was the case with MLPs and distributable money flow, and because the market prevailed, stocks of pipeline MLPs collapsed.
I describe the story of Kinder Morgan and MLP in my book since it emphasizes first principles. The discounted money flow model (DCF) is universal. So what do I mean by that? And what are basic principles? Let’s take the P/E ratio. Although any valuation multiple could be expanded right into a DCF model, P/E ratios will not be necessarily shortcuts to the DCF model. If used incorrectly, they will result in incorrect conclusions about an organization’s value.
For example, a P/E ratio of 15 could also be low-cost for one company and expensive for one more. This is because certain variables have a confounding effect that limits what valuation multiples can let you know a couple of stock’s value. The low-cost company could have billions of dollars in net money on the books and big growth prospects, while the expensive company could have billions of dollars in debt and poor growth prospects. Yet they still have the identical P/E ratio.
Valuation multiples could be helpful in the event that they are used accurately and you realize what they represent. This low P/E stock may not be low-cost if the corporate has huge net debt. A stock with a high P/E ratio might not be expensive if it has few assets, a pristine net money balance, and offers tremendous free money flow growth prospects. However, many analysts have forgotten that P/E ratios are an imperfect substitute for the DCF model and mustn’t be utilized in isolation.
This has opened the door to all forms of false financial evaluation. Think of all of the quantitative aspects that statistically “explain” returns based on this or that multiple. There are hundreds of forward-looking assumptions embedded in every valuation multiple. Just because this value is high or low doesn’t suggest the stock is a superb buy.
Many analysts today apply P/E, P/E, EV/EBITDA, and other multiples individually, as in the event that they were distinct from the underlying DCF model from which they arrive. Some even query whether the DCF model continues to be relevant. In the meme stock era of GameStop and AMC Entertainment, does it still make sense to forecast future free money flows and discount them to today at an inexpensive rate?
The answer is yes. When it involves valuation, basic principles remain essential: behind every valuation multiple there’s an implicit DCF model.
With MLPs, we all know what was incorrect with their valuations. Relying on “distributable” metrics is like evaluating Meta by subtracting only an estimate of its “sustainable” capital expenditures while completely ignoring its Metaverse-related growth investments – and yet giving the corporate the longer term ones generated by those expenditures credits money flows.
The MLP bubble shows that applying valuation multiples and not using a supporting DCF model could be a recipe for disaster. In fact, using valuation multiples won’t provide much insight and not using a solid foundation in the fundamental principles of investing. Only the DCF model will help determine which 15 P/E stocks are low-cost and which will not be.
Such errors may help explain the replication crisis in empirical quantitative finance. I imagine that almost all statistical analyzes that specify stock market returns through valuation multiples are flawed. The ratio between stocks with similar metrics hasn’t really held up lately. Why did we ever think it could or may very well be so?
If we understand that two stocks with the identical P/E ratio could be undervalued or overvalued, why should we imagine that the performance of stocks with similar valuation metrics would supply usable data? And what does this mean for the discussion between value and growth? If we do not use the DCF model, we could all be on the incorrect path with regards to value and growth.
All of this explains why the DCF model just isn’t only relevant to today’s market, but continues to be an absolute necessity. As the 10-year Treasury yield rises and stocks come under pressure, we’d like to regulate the DCF model. Finally, these returns form the idea for the weighted average cost of capital assumption.
In this changing landscape, a return to basic investing principles is inevitable, and the DCF model is a necessary tool for navigating the longer term.
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Photo credit: ©Getty Images / Kazakov Anatoly Pavlovich
