This article takes a detailed look at understanding investment valuations when making decisions, looking at current examples to drive home important lessons. Particular attention is given to the importance of discounted cashflow.

The following article comes from Paul Beland, head of equity research at CFRA. The editors are pleased to share these views; the usual editorial disclaimers apply. Email tom.burroughes@wealthbriefing.com if you wish to respond.

Finding the right investments to buy, hold, or sell to produce long-term outperformance requires a rigorous fundamental analytical approach that can include both quantitative and qualitative interpretations. Often requiring multiple lenses on valuation and deep sector expertise. 

Wealth managers and investors are overloaded with investment recommendations from sell side research firms, robo-analysts, and algorithmic quant models, all leveraging different approaches to investment valuation. The output can be confusing and often conflicting, leading to difficult decisions and discussions with clients when they miss the mark. It’s important that investors not only know the methodological investment valuation approach being followed, but also the potential pitfalls inherent in valuation approaches. 

It’s often said that investment valuation is more of an art than a science. While this can be true, ultimately, valuation analysis is grounded in the fundamental principle that the value of an asset is the present value of its future cash flows. Intrinsic valuation techniques relate the value of an asset to its ability to generate cash flows and risks related to those cash flows. In its most common form, intrinsic value is estimated using a discounted cash flow model or a “DCF.” These models are complex, with lots of assumptions that are hard to estimate effectively. 

First, estimating company profit trends, or when a company is expected to generate free cash flow and at what part of its life cycle, is difficult. Second, the model is assuming trends into perpetuity - yes, infinity, forever, no end date. In addition, depending on market sentiment, DCF might not be effective in finding undervalued or overvalued stocks, as it does not factor in market sentiment or relative valuation of competitors. 

Let’s take a look at a couple of examples where relying solely on DCF analysis might have missed the mark. We’ll look at one case that would have likely signaled a Sell recommendation and missed a generational wealth creation opportunity, and one that could have led investors directly into a value trap.  

Generational wealth. While the jury is still out regarding how high and how long investor enthusiasm will propel AI-tech darling NVIDIA (NVDA), it’s a great example of a company that would have been incredibly difficult to effectively value solely with intrinsic valuation. Let’s rewind the clock four years, before the recent AI craze. Investors would have had a great opportunity to purchase shares of NVDA at less than $50/share in late 2019. However, NVDA’s annual FCF was only about $5 billion, so investors would have been justified in their skepticism.

Thus, to justify its valuation at the time using DCF, NVDA would have needed to grow its FCF roughly 2,000 per cent over the following ten years and 90 per cent of its imputed value would still have been determined by its terminal value into perpetuity at year eleven. It’s difficult to forecast FCF relatively accurately a few years out, let alone into perpetuity ten years out! This is why DCF can be useful sanity check on valuation, but it can leave investors with steep opportunity costs as a singular tool. 

In the case of NVDA, a better approach to valuation would have been to overlay DCF analysis with a longer-term price/earnings multiple analysis given its growth profile. For example, based on year +3 EPS estimates, the firm's P/E was in the low 20s range. As the company shifted towards AI-enabled servers over traditional servers, NVDA’s increasing emphasis on CPUs and networking further expanded its content growth potential inside both traditional and AI servers, which could still be underestimated by current market expectations. As always, growth stocks with a disproportionate amount of equity valuation being driven by estimates of longer-term profitability have risk to paradigm shifts and revaluation. Nevertheless, looking back four years, it’s clear the extent to which NVDA’s disruptive impact and associated growth was underappreciated by the market.