Analytical models are just a way to express your thoughts. Analysts spend so much time building highly complex models, complete with revenue builds and an absurd number of line-items to determine their price targets.
Now, although these are absolutely useful in understanding a company’s financial condition, margins, growth, etc, I feel that they are extremely unreliable when trying to determine what price to purchase a stock at. There is far too much ambiguity. If you, me, and ten others all built a model and DCF valuation for P&G, we would likely all come up with a different price targets.
Some reports even use absurdly high multiples in their valuations, which they justify with tons of bullish scenarios. This becomes problematic when analysts are incentivized to put out “buy” recommendations. Furthermore, analysts do not have skin in the game (Nassim Taleb) with their recommendations.
Even if an analyst can perfectly project a company’s financials and link it all into a FCF DCF, there is no guarantee the company’s stock price will align with its calculated intrinsic value. If all the analyst are all determining their opinion using different models and valuation methods, the stock’s price won’t line up precisely with the target of the one analyst who did it correctly. I feel that it is better to do your own due diligence and make your own conclusions.
A few people also dispute the legitimacy of such valuation methods, I highly recommend you guys to listen to this podcast between Tobias Carlisle and Dan Rasmussen, two deep value fund managers. It covers a few topics and after their discussion on investing with leverage, the podcast points to some of the issues with valuation methods like Porter 5 forces, DCF etc… They also discuss a number of third-party research papers, which point to the fact that knowing more about an industry or a company doesn’t necessarily mean you are a better stock picker and that your returns will be higher. David Epstein, author of Range: Why Generalists Triumph in a Specialized World also points out to the blindness of experts (see this article https://www.theatlantic.com/magazine/archive/2019/06/how-to-predict-the-future/588040/) and that these so-called experts are not more likely to get to the right stock price than you and me.
Many investors like to dive deep into the woods to build monster financial models for their valuations. I’ll admit that it can be fun doing this as a sort of puzzle. However, I believe that after a certain point, the more complex the model, the less accurate it will be. My valuation methods are generally pretty simple. Firstly, I familiarize myself with the company’s financials and understand the key drivers and metrics to watch. Secondly I use a combination of valuation methods (DCFs and EV-based or Price multiples) to determine the range of price which I’m looking at. Finally, you add on a margin of safety (i.e. 10-20%) to compensate for unexpected events and forecasting error. The rest of my time goes into understanding the nature of the business as it adds significantly to your margin of safety.
I guess that’s how things were framed in Corporate finance and most CEOs would discuss valuation using these parameters. Does it mean I will get a more accurate stock price target or better returns than you or a monkey choosing a random set of numbers? Probably not but that’s what I am comfortable with and I personally enjoy learning about companies, products and business models. It helps me rationalize and think of the reasons why I invest in a company vs another company or an index. That’s also how most of the institutional investors and analyst look at things too, it doesn’t mean it’s better.
In short, focus on the quality of the business that you are looking to invest in. Analysis reports can be a reference to see if you have missed out anything important in your own research, but do not solely rely it to determine which stocks to buy. Also, there is no need to get analysis paralysis on getting its financial picture and valuations right to the decimal point.
Cheers