James Montier who is a member of GMO’s asset allocation team (formerly at Societe Generale) had published this excellent piece about “The Dangers of DCF” in 2008. I came across this article last night. These and other excellent articles can be found in his book Value Investing: Tools and Techniques for Intelligent Investment
Today, I read this article from Barrons online about Netflix (NFLX)
See the part italicized below.
“Our target prices on NetFlix have always been justified by a blend between target multiples and a discounted-cash-flow analysis with a discount rate derived from the Capital Asset Pricing Model (CAPM). NetFlix is now at a level where using target multiples simply does not make any sense. However, plugging these new assumptions into our master DCF model now allows us to justify a target of $130 [up from $120], still offering 18% upside from current levels.
This is precisely the argument that James Montier was making against DCF. The DCF valuation method is often used to justify higher valuations for stock prices by keeping an eye on current stock prices.
I did a cursory analysis of NetFlix ( A company I really admire )
Netflix is trading at
P/E (ttm) = 49x
P/E (fy2011)= 30x
P / FCF = 5770 / 280 = 20x
EV / EBIT = 28x
EV / EBITDA = 23x
Reverse DCF shows me that 20% FCF growth for 10 years has been baked into the stock at current levels. ( assuming 15% discount rate).
Netflix is the leader in DVD rentals and leading the streaming video transformation, it has executed well, has media hype going for it with various product launches on the Ipad/Iphone/Xbox/Wii/PS3 platforms, sports a strong balance sheet, insiders own 10% of the stock. However, I do not think that shares of Netflix are attractive at current levels.
Value Investing teaches us
1) consider risk before return.
2) Investment gains depend on your purchase price ( not on the outcome of the business)
3) Investment gains are realized when you buy low relative to the intrinsic business value and with a margin of safety, and then sell at fair valuation.
Wall Street wants us to buy high and sell higher. Look forward to your thoughts.