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“The value of an equity, bond, or businessToday is determined by the cash inflow and outflow expected to occur during the remaining life of the asset.”
– Warren Buffett
He was paraphrasing John William Burr when Warren Buffett explained that the value of all stocks, bonds, or business is a function of future cash flow. Theory of investment value.
But Barr did not invent the idea behind his calculations.
The instance first recorded to present future cash flows in 1773 when engineer Edward Smith estimated the “present value” of a coal mining operation based on future revenue streams.
In fact, the logic of present value has been in use for even longer than that.
In his publication Free Abasi In 1202, Leonardo Pisano (better known as Fibonacci) was recognized as “first to develop a current value analysis to compare the economic value of cash flows on alternative contracts.”
823 years later, it is still the best way to do it. Discounted cash flows are as close as possible to the basic truths of the art of financial assessment.
But it rarely feels that way, but it’s confusing. The best argument for DCF is that it doesn’t match our living experience as investors.
For example, stocks are not able to identify cash flow logic in price charts, even in hindsight, for reasons that have absolutely nothing to do with future cash flows, trade ups, downs, and for all reasons.
John Maynard Keynes is right to call out the stock market where he invests in “beauty contests” that are unrelated to the basics. Nor does it dispute Robert Schiller’s findings that the stock price is far more volatile than could be explained by subsequent changes in dividend payments.
However, I am caught up in the conclusion of Austrian economist Karl Menger that “value does not exist outside of male consciousness.”
Inferring value from price movements (and human behavior) is like concluding that stars unfold around Earth.
It is true that DCF cannot be proven in a mathematical sense. It is not the physical laws of the universe.
But it’s as close to the law as we can get from finance, but it’s irrelevant as to how asset prices work in the real world.
This can be simulated in thought experiments.
For example, imagine you were asked to bid on two assets. This could be guaranteed to pay $10 a year to the owner over the next 10 years.
Which one do you offer the money?
Of course, Asset A can calculate the amount it offers by placing a predictable stream of future cash flows in an Excel model and discounting it to the current value.
You can do that for Asset B as well. However, it doesn’t really help much, as you have to guess all the inputs in the model.
But in theory, it’s still mental A model used to understand why financial assets are valuable.
Asset A in the example above is of course a bond, and Asset B is a stock, so it is rare for people to use the DCF model for their stocks.
DCF models require too much guessing about what happens too far in the future (usually up to 10 years, and even that is too short to really know).
Instead, we like to look at one, two or three years later, guess for example one revenue and choose a somewhat arbitrary multiple of that guess to reach the price target.
However, the price target is a prediction of where the stock will go. Tradeit’s not worth it.
Metrics such as price to revenue, price to sales, price to eBitda and more – all of these replace stocks’ unfamiliar discounted cash flow valuations.
No matter how much you want to think about it, it remains the current value of future cash flows that is worth any inventory.
This is why, even with Warren Buffett, building DCF models, rarely anyone actually value inventory this way.
“Warren often talks about these discounted cash flows,” Charlie Munger once said. “But I’ve never seen him do that.”
That’s because Munger and Buffett were worried that the “false accuracy” of the DCF model would likely lead them to confusion.
In other words, you need to know that the value of a financial asset is a function of future cash flows, but don’t try to calculate it.
For investors, DCF is not a practical playbook, it is a state of mind.
But Crypto is different, right?
In the latest episode of Empire Podcast, Crypto Investor’s Tom Dunleavy predicted that the fees people pay for using layer 1 blockchains like Ethereum will be “virtually zero.”
That made me reaffirm the title of the podcast – “The Bull Case for Ethereum” – as it sounds like the ultimate Bear For cash-oriented investors like me.
But Dunleavy thinks I’m wrong. When evaluating layer-1 tokens like ETH, “revenue and cash flow are totally wrong to think about it.”
Instead, L1 should be valued “as a percentage of assets that will become on-chain at some point in the future.” (“In theory,” he adds.
He may be right about that, I don’t know – and he may also be right price ETH correlates with the amount of assets in the Ethereum host (but that remains as speculation).
But to claim it value Ether is based on anything other than future cash flows, and claims that ether is exempt from Buffett’s dict regarding stocks, bonds and corporations.
Many people think that should.
For example, “Ethereum Investor” Ryan Bergmans makes the etheric claim by rebutting the idea that it is a business selling block space.
Probably so – but how else do you measure it? investment In freedom and prosperity, how many people pay to access it by predicting?
Berkmans may have implicitly admitted the point later in the podcast, saying, “Yes, something worthwhile will happen through long-term fees.”
It sums things up for me: for some reason I buy a crypto token, certainly – freedom, prosperity, atmosphere – but only way Invest The assumption is that the current price is justified by future cash flows.
