We regularly get asked how Conscious Investor is different
from the countless "value" based software products
and books available.
The vast majority of "value" approaches are based
upon a standard discount cash flow (DCF) model. They all
purport to find what is called the intrinsic value or true
value of a stock. This is the value the proponents claim
that all rational investors should pay for the stock.
Many of the authors and investment websites claim to base
their intrinsic value approach upon the methods of Warren
Buffett. In fact, it is actually very unlikely that he really
uses any of these methods in anything vaguely resembling
a formal approach.
For example, Charlie Munger, the old friend of Buffett
and the Vice-Chairman of Berkshire Hathaway, says that he
has never seen Buffett do any discount value calculations.
This is consistent with the answer he gave when asked about
intrinsic value at the annual meeting of Berkshire Hathaway
in 1996. "There is no formula to figure it out."
He replied. "You have to know the business."
Until recently, Buffett had never used a computer for anything,
let alone for implementing any value models. Now he only
uses it to play bridge on-line.
When people write about Buffett I usually agree with most
of the general observations made about his approach. The
one area where Conscious Investor differs from the majority
of Buffett followers (but quite likely not with Buffett
himself) is in relation to the "valuation" model
There are large numbers of DCF models. Stable growth models,
two-stage models, three stage models and so on. Each of
these models calculate the intrinsic value of the stock
by discounting back to present time the stream of "cash"
that is generated by the business. All I can say is that
it is hard to believe that such simplistic and unreliable
material is still taught in universities and promoted by
The main problem is that people think that just because
they can put some numbers into a formula they have found
a useful and realistic model. Here we are talking about
all the academics and writers who have limited understanding
of the interface between mathematics and the real world.
Two Fatal Weaknesses
There are two fatal weaknesses of any DCF model.
The first is that DCF models are unstable — small
changes in the input values can lead to such large changes
in the output that almost any number can be obtained.
Here is a simple example showing just how unstable intrinsic
value calculations are. The model uses the standard two-stage
We assume that the company spends ten years in the initial
stage during which the cash per share (generally the free
cash flow) that it generates grows by the rate given in
the second column. After the initial stage comes the steady
state period. During this period the cash is assumed to
grow at the rate described in the third column. Finally,
everything is discounted back to present time using the
rate given in the fourth column.
With small changes in the input variables, the output can
shift from $23 to $58. I can't help getting the image in
my mind of the host of an old television show saying, "Would
the real intrinsic value please stand up?"
Initial Growth Rate
Final Growth Rate
And then you have to do the same estimate for the discount
If a model with this level of instability was proposed
in a science class, it would be thrown out of the window.
The second fatal weakness is that just because some model
says it is generating something called intrinsic value does
not mean that it is providing anything that really is "intrinsic
value". And it certainly does not mean that it is giving
something useful for investors.
For example, just because a stock is undervalued (by some
model or other) does not mean that it won't stay undervalued.
This is quite different from saying that if a company has
a strong economic performance, then eventually the market
will acknowledge this by increased stock prices.
The instability described above is compounded by the fact
that it is impossible to confirm the accuracy of two of
the input variables. For example, the entry for the final
growth rate requires that you estimate the growth rate of
the cash not for another ten years, or even twenty years,
but out to infinity! This is despite large studies showing
that analyst forecasts for earnings over five years are
no better than random.
In contrast, in Conscious Investor we don't try to calculate
the mythical concept of intrinsic value. We don't talk about
whether a stock is undervalued or overvalued, whatever that
may mean. Rather we define value in terms of the return
you will get on an investment.
Instead of intrinsic value, we talk about investment value
or investment return. This is calculated using the proprietary
tools STRETTM and STRETD®. STRET is a calculation
of the annualized percentage profit or rate of return from
owning the stock. STRETD is similar except that it assumes
that dividends are reinvested.
By calculating the actual return you can anticipate on
your purchases, you get practical criteria whether it is
worthwhile buying stock in a particular company or not.
So in a nutshell, if you were to compare the stocks selected
by Conscious Investor with other "value" models
freely available on investor websites, you are unlikely
to find much overlap between the selections.
Despite the best intentions of would-be intrinsic value
systems, the way that DCF models work either provide you
with more or less random stocks or with stocks that you
like and you (unconsciously) manipulate the data to make
them appear undervalued.
The Conscious Investor for more details ...
The book The Conscious Investor: Profiting from the Timeless Value Approach by Dr John Price covers over 30 valuation methods including their assumptions, and their strengths and weaknesses.