Saturday, October 22, 2005


I'm happy to introduce readers to a fine stockpicking blog, Wershovenist Pig, on which I'm listed as a Hog-Friend. Among many interesting things you'll find there currently are analyses of spirits maker Diageo (DEO) and retailer WalMart (WMT). The Head Pig is proficient at conducting a discounted cash flow analysis (DCF).

If you don't know what that is, don't despair. It's a common way for many pros (and non-pros) to value a stock or a business (which is what a stock represents). Take the "free cash flow" (a bit different from earnings) you think the business will generate in the future and discount it back to the present based on what you can get in a safe investment (like a US Treasury Note) plus an added risk premium. That's it. Anyone with junior high school math under his belt can do it. It's just a kind of reverse interest calcuation. Instead of adding interest to a pile of money now to see what it will be worth in the future, you're subtracting interest (and a risk premium) from imaginary -- hopefully not too imaginary -- cash flows in the future to find out what they're worth today.

The devil is, of course, in the details. How does anyone know how much cash WalMart will generate over the next decade, and what's the proper discount rate? Warren Buffett might reply to the first problem by saying that with a company like WalMart, which has a long history of free cash flow generation, you can be apporoximately right about its earnngs or free cash flow generation in the future. Then, if you can buy the stock for cheaper than the present value of those future cash flows, have an adequate "margin of safety" in case you're overly optimistic about WalMart's future, you're, as they say, in business. (The discounting technique, by the way, indicates why stocks can be "interest-rate sensitive" or why rate increases often drive prices down. If you can get more from a safe investment like a Treasury Note, then you must demand more from a stock investment, which means its earnings must go up or its price must come down.)

Anyway, go to the Pig to see the technique in action.


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