A few months ago my colleague, Sam Ford, explored the magic of compounding in his excellent blog: The Greatest Shortcoming of the Human Race. In this post, I’d like to flip his ‘Power of Compounding’ on its head and explore ‘The Dangers of Discounting’.
The most conventional approach to valuing a stream of future payments is to discount those payments at a chosen discount rate to arrive at today’s value of that future payment stream – referred to as its Net Present Value (NPV). Almost everything with a relatively certain set of payments, from annuities to mortgages to auto leases gets valued by this method.
This is how fixed income instruments such as government bonds have been valued for time immemorial. In the early 1950s, equity market participants and project evaluators took a page out of the bond market’s valuation playbook and began employing this same method to value other assets such as corporations and infrastructure projects. The approach was the same: simply forecast the project’s or business’s future earnings and cash flows, apply an appropriate discount rate, and arrive at its Discounted Cash Flow (DCF) valuation.
Unfortunately, as convenient as it might be, this conventional approach does have its imperfections.
One well-understood problem with the DCF valuation approach is that longer-term cash flows beyond a decade-and-a-half or so tend to go unappreciated – they simply get discounted away and contribute very little to the total.
But probably the biggest problem with DCF-based valuations of long-dated cash flows arises when uncertainty in the cash flow stream (and/or the environment in which they’re earned) comes into consideration. This is particularly true for businesses whose long-term corporate earnings and cash flows are notoriously difficult to forecast.
Concerns around discounting long-dated, uncertain cash flows have been voiced by Eugene Fama, a main architect of modern financial theory, often referred to as ‘The Father of Finance’. His seminal paper, Discounting Under Uncertainty (1996), highlights the disproportionately unusual valuation results when measured over longer and longer investment horizons. His work on the shortcomings of DCF-based valuations has been popularised by Dr Arturo Cifuentes from the University of Chile, in articles such as the highly readable The Discounted Cash Flow (DCF) Method … Too Many Uncomfortable Truths (2014).
To illustrate how uncertainty about the future can distort outcomes and behaviour, consider the following three cash flow streams:
- Stream 1 Grows steadily each year, for the duration of the 30 years
- Stream 2 Grows more quickly than Stream 1 until the tenth year, and then remains unchanged at that level for the subsequent 20 years
- Stream 3 Grows even more quickly than Stream 2 until year 10, and then declines steadily for the subsequent 20 years
Considering your current financial situation, and making your own assumptions about the next 30 years (inflation, interest rates, tax rates, foreign exchange rates, lifestyle requirements, healthcare needs and any other relevant consideration), which cash flow stream would you choose?
I asked this question to dozens of M&G colleagues, providing only the visual representation above (ie, no hard numbers). The results were fascinating. The cash flow stream with the highest DCF valuation got the most votes – Stream 3 – whose enhanced short-dated cash flows skew the outcome in its favour.
But while Stream 3 got the most votes, more than half of all respondents did not pick the most valuable cash flow stream. Why could this be?
Perhaps there’s a clue in a second question asked of each of them:
“What if your chosen cash flow stream was to be an essential source of future income, upon which you would be exceptionally reliant for the next 30 years? Would you make a different choice?”
Despite the obvious fact that the cash flow streams’ DCF valuations don’t change under this scenario, nearly a third of respondents did in fact change their mind. The majority switched to Stream 1, followed closely by Stream 2.
While by no means a rigorous statistical study, this appears to illustrate Fama’s and Cifuente’s points quite clearly: inject a bit of risk and uncertainty about the future and human nature tends to kick in – in this case, perhaps even a hint of survival instinct. I imagine for many, myself included, the prospect of relying heavily on a flat or declining cash flow stream in an uncertain future becomes a bit less appealing.
So what can we take away from this little exercise, and more importantly, how can we capitalise on what we’ve learned?
Consider Stream 1 for a moment, and think of it as the cash flow stream from a sustainable, long-term equity investment delivering a consistently growing dividend. The infrastructure sector is rife with investment opportunities such as this – think of toll roads, airports, energy pipelines, for example, to which we have exposure in M&G funds.
Well it might surprise you, but on a DCF basis, Stream 1 happens to be the cheapest of the three cash flow streams illustrated above – a bargain for those that chose it. This highlights that DCFs should not be looked at in isolation and instead an individual’s circumstances, preferences and long-term needs have to be taken into account. The investment with the highest DCF valuation is not always the best choice.
So while behavioural biases normally disadvantage the average investor, perhaps on this occasion the opposite is true. For long-term, income-oriented investors facing what seems to be an increasingly uncertain world, I would argue there are unique, attractively valued investment opportunities akin to Stream 1 that can reliably satisfy their financial needs and preferences.