The Prudence Trap

Since I just don’t know what to do with myself after finishing the CFA program, I’ve recently begun working my way through Damodaran’s valuation class. He put up a slide that I wish I would have seen years ago, because it highlights a mistake in valuation that I only recently began correcting.

Here it is. Look closely!

prudence trap

Do you see the difference? He’s saying EITHER do your valuation using expected cash flows and an appropriate discount rate OR do your valuation using worst-case cash flows but use a far lower discount rate since the worst-case cash is almost certain to materialize.

Until about a year ago, here was me. Make sure it’s not you.

    “Hmmm… analysts are pegging the 5-yr earnings growth rate at 8%. I’ll cut that in half to be conservative…”

    “This large cap has tended to trade at a multiple of between 15x to 20x on core earnings. I’m going to assume a terminal multiple of 15x to be safe. Growth, and therefore P/E should shrink over time, right?”

    “At these low interest rates, the required return for most investors is probably about 7% for this big, safe company. But I want to make 15% regardless, so that’s the discount rate I’ll use.”

    “This company has paid a dividend for decades, but I know never to buy a stock for the dividends – they could get cut off at any time – so I’m excluding their effect and going for a 15% capital gain. If I get the dividends, that’s just gravy.”

    “Ditto on the fact that the management has been buying back shares in recent years. I’m not counting on that continuing.”

    “OK, got it all in the spreadsheet, and I’m getting $40 as an attractive buy price. But I want a 50% margin of safety as Graham taught, so my entry point will be $20.

    No, I don't still do valuation this way
    No, I don’t still do valuation this way

Head on over to Yahoo Finance to check last trade…

Screen Shot 2013-04-30 at 11.34.22 AM

    “Outrageous! What idiots are buying at this price?! I’ll just be disciplined and patient, and wait for Mr. Market to wake up on the wrong side of the bed one day and give me my price. I bet he’s offered that recently, let’s look at a chart to see when P&G last traded at $20…”
Uh oh...
Uh oh…

So let that be a lesson to you.

Read your Ben Graham and Joel Greenblatt and attempt to buy $1 bills for 50 cents, but make sure you’re not really trying to buy $1 bills for a nickel. You’ll never end up buying anything.