Financial Projections are the key to understanding the role of Discounted Cash Flow (or DCF) in Value Investing.
Discounted Cash Flow
DCF is a method of evaluating an investment, based on projections of its future cash-flows. The current value of such cash-flows is evaluated by using a discount rate — also an estimate — to calculate the current total DCF value.
DCF and similar analyses require subjective projections into the future which are outside the domain of Value Investing. Any DCF analysis requires future cash-flow projections, as well as an assumption about the appropriate discount rate.
Financial Projections
Warren Buffett and his mentor, Benjamin Graham, have both spoken about the futility of financial projections on multiple occasions.
Graham's stock selection framework only requires objective figures from the past — including checks for past growth rates — and requires no assumptions about the future.
Discounting future earnings or free cash-flow projections, to arrive at present value estimates, also falls well within the realm of advanced math. They usually require spreadsheet software to solve, at a minimum.
Benjamin Graham's Value Investing framework relies instead on simple arithmetic — which can be done on paper or a calculator — and requires no subjective projections of cash-flows or estimations of discount rates.
"Operations for profit should be based not on optimism but on arithmetic."
Benjamin Graham, Chapter 20: “Margin of Safety” as the Central Concept of Investment, The Intelligent Investor.
"He tried to keep things simple. He wrote that he didn’t believe security analysts should use more than arithmetic and possibly a little algebra for any investment decision."
Walter J. Schloss, Benjamin Graham and Security Analysis: A Reminiscence (1976) [PDF].
Buffett on DCF
When asked how he arrives at a stock's Intrinsic Value, Warren Buffett often refers to its DCF as being its Intrinsic Value. But he never actually says how he calculates this Intrinsic Value or what projections he uses for such calculations; presumably for the obvious reason that he never uses projections, by his own admission.
This reference to DCF is possibly thus nothing more than a deflection on Buffett's part, to avoid having to explain something so complex — the advanced Intrinsic Value evaluation techniques used within Berkshire Hathaway.
But Buffett has repeatedly stated, on record, the path to learning investing correctly starts with Graham.
So how does one apply DCF in Value Investing? The answer is that one doesn't.
Watch Videos
Two Methods
In this first video, the audience member notes that Buffett doesn't like talking about Intrinsic Value but asks about it anyway. But Buffett and Munger deflect as usual, saying they give all the data required to arrive at the estimate in their annual reports.
They also say that they each use different methods, which again hints at an advanced evaluation process.
Interest Rates
This second video is even more interesting, since the audience member specifically asks why Buffett doesn't share his Intrinsic Value formula.
Again, Buffett deflects in his usual manner; but this time, he also mentions the significance of Interest Rates in arriving at Intrinsic Value.