Table of Contents
16.1 – Drawbacks of DCF Analysis
In this chapter, we will discuss some of the important issues that can have a huge impact on your investment decisions. In the previous chapter, we saw how to calculate the intrinsic value of a company’s stock using the DCF model. To find out the intrinsic value of a company DCF is probably the best approach. But this method also has its drawbacks. You should also know about these drawbacks. _ As we have discussed earlier, the DCF model is based on your assumptions. _ _ _ _ If your guess is not correct then this model won’t work ok and you won’t know the exact price of the share.
- DCF requires forecasting – You know that in the DCF model, we need to forecast future cash flow and the business cycle. Doing this is a big challenge not only for the fundamental analysis but also for the top management of the company.
- It is highly affected by the terminal growth rate – The DCF model is highly affected by the terminal growth rate. Even a small change in the terminal growth rate has a big impact on it. For example, in the case of ARBL, we assume a terminal growth rate of 3.5%, after which the share price comes out to be ₹368. But if we change the terminal growth rate to 4% instead of 3.5%, then the share price will change to ₹394.
- The model needs constant changes – Even once the DCF model is created, the analyst has to continuously improve it. As quarterly and annual data comes in, the analyst has to make adjustments to the model by incorporating this data and changing his estimates.
- Its focus is long-term – the DCF model completely looks towards long-term investment. For any investor who wants to invest for less than a year, the DCF model does not make any sense.
Apart from this, you may also miss many opportunities because of the DCF model as this model follows very strict criteria. To avoid these weaknesses, it is important that you try to keep your assumptions as low as possible while using this model. Some guidelines for making a good guess :
- Free Cash Flow (FCF) growth rate – The free cash flow growth rate should never exceed 20%. No company can consistently grow free cash flow at 20%. If the company is new and growing fast then you can give it a growth rate of 20% but above the 20% rate is not even for any company.
- Estimate the number of years – You can assume that the more years you estimate, the better. But it is also true that the longer your estimate is, the more likely it is to make mistakes. That’s why I usually estimate up to 10 years. And in that also I extract DCF in two steps.
- Find the DCF in Two Steps – A good approach is to break down the DCF analysis into two steps. We used this method in the previous chapter in the example of ARBL. Out of 10 years, a different rate of FCF was kept in the first phase i.e. 5 years and another lower growth rate was kept in the second phase i.e. in the subsequent 5 years.
- Terminal Growth Rate – As we have already discussed that Terminal Growth Rate plays a very important role in the DCF model because even a slight change in it brings a lot of change in this model. Therefore it is necessary to keep the terminal growth rate as low as possible. Personally, I never keep the terminal growth rate higher than 4%.
16.2 – Margin of Safety
Remember, no matter how carefully you guess, mistakes can still happen. To avoid the effect of this mistake, the principle of margin of safety comes into play. This theory was presented by a man named Banks Benjamin Graham in his book “The Intelligent Investor”. This principle states that any investor should buy shares only when that share is getting cheaper than its intrinsic value. By the way, keep in mind that setting a safety net cannot make you a successful investor, but yes, the effect of your mistakes can definitely work.
Let me show you an example of how I use the principle of safety margin or margin of safety in my investments. Let us once again take the example of Amara Raja Batteries Limited. The intrinsic value of the stock is ₹368 per share, in which we have applied a modeling error of 10% to get the intrinsic value band. The bottom price of this band is ₹ 331. The principle of safety margin tells us that we should buy shares cheaply even from the lower band of the intrinsic value. Usually, I buy shares only when they get 30% below the lower band price.
You may ask what is the need for this? Are we not working too carefully? Probably yes, but it is necessary to save yourself from wrong assumptions and their consequences. Look at it this way, suppose you like a stock at ₹100, if it gets at ₹70 then it would be a really great thing. A good value investor always thinks like this.
Back to ARBL once again.
- The intrinsic value of the stock is ₹368
- After keeping a band of 10% to avoid modeling error, the lower band comes to ₹331
- After reducing it by 30% i.e. after applying the margin of safety i.e. after applying the security scope, this price becomes ₹ 230.
- At ₹230 it can prove to be a very good investment
Remember, as soon as a good stock starts getting below its intrinsic value, value investors come to buy it and in such a situation, if the stock is getting even lower with a margin of safety, then this opportunity should not be missed. Very few get such an opportunity. Also remember that such opportunities are usually found only in the bear market i.e. bear market, when people want to stay away from stocks or their thinking about the market is very pessimistic. Therefore, if you have money in the recession market, then you can get a good investment opportunity.
16.3 – When to sell?
Throughout this module, we have talked about buying shares. But what about selling? When should we sell? When should profit be booked? Suppose you bought ARBL shares at ₹250 and now it is trading at ₹730 per share, that means you have made a profit of 192% , which would be considered a pretty decent return, especially when You have earned it in 1 year. So does this mean that you should sell the stock now and take profits? The time to sell a stock is when there is such a flaw in it that it is no longer investable.
Not worth investing in – Remember, buying a stock is not decided by price. We are not buying ARBL just because it has fallen by 15%. We are buying it because the stock fulfills all the conditions of investment and hence it is an investable stock. But if that stock is no longer investable, will we buy it? Probably not. Taking this point forward, we can say that the stock should be held as long as it is an investable stock. It is possible that all those things remain in the stock of a company for many years due to which it remains an investable stock. It means to say that as long as that stock is investable, it should remain in the stock because of this the price of the stock keeps increasing and earning for you.
16.4 – How many stocks should be there in the portfolio?
How many stocks should be in your portfolio? There is a lot of debate on this, some people say that by holding more shares you can diversify your portfolio and some say that if the shares are fewer then you can earn more. We take a look at what some well-known investors have to say about this :
Set Klarman – 10 to 15 stocks
Warren Buffett – 5 to 10 Stocks
Ben Graham – 10 to 30 Stocks
John Keynes – 2 to 3 stocks
I have 13 stocks in my own portfolio and I never want to hold more than 15 stocks. Probably no one should have more than 20 shares.
16.5 – Final Conclusion
In the last 16 chapters, we have discussed various topics to understand the fundamental analysis of the market. Now let us once again look at those important things which we should remember –
- Be rational – there are ups and downs in the market. But if you have the patience to stay in the market, then you will get profit from the market. You can earn up to 15 to 18% which is a very good earning. Remember that don’t be in the circle of earning 50% or 100% because even if you earn like this for some time but it can’t be for long.
- Take a long-term view – We talked about in Chapter 2 why any investor should take a long-term view. Remember that the longer you stay invested, the more you will get the benefit of compounding in the market.
- Look for investable conditions – Always look for such shares or stocks in the market in which the investable conditions are being fulfilled. As long as those conditions are fulfilled in those shares, stay in them and when you feel that this company is no longer worth investing in, then get out of it.
- Always give importance to the quality of the company – Quality or character is always more important than numbers. While choosing investable companies, look at the character of the promoters.
- Avoid the noise and use the checklist – If you stick to your checklist and use it regardless of what is being said on TV or in the newspapers, you will definitely invest in a good company. Will find
- Use of Margin of Safety – Remember it will save you from bad luck
- IPO / IPO- Avoid buying IPO. IPOs are usually expensive. If you want to buy an IPO, then look at it according to these three steps of equity research.
- Keep learning – understanding the market is not easy it takes your whole life so always try to get as much information and learn as you can.
Now I want to tell you about four such books which will help you understand investing.
- The Essays of Warren Buffett: Lessons for Investors & Managers
- The Little Book that Beats the Market – By Joel Greenblatt
- The Little Book of Valuations – Aswath Damodaran ( The Little Book of Valuations – By Aswath Damodaran)
- The Little Book that Builds Wealth – By Pat Dorsey