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.

2 thoughts on “The Prudence Trap”

  1. Haven’t been here for a while. Nice to see you have “free time” now that the CFA program is behind you. 🙂

    There are only a few more weeks until I sit for the CFA L3 exam and I feel, as always, under prepared and feeling like I’m sending myself into a gun fight equipped with nothing more than a knife. Looking back to one of my old posts, I mentioned I was sitting for the L2 exam for the third time and well, since I’m writing L3 I obviously passed. Man, L2 was a killer! I just want to pass and move on with my life and have what you say, “I just don’t know what to do with myself.”

    Did you have a chance to write any of the L3 Schweser Practice Exams? I have written the first 5 and well, the results are pretty discouraging, two 57s, two 52s and a 70. I know it’s not the results that matter before the exam as long as you learn from your errors and peak on exam day but seeing those results hurt. Even after 4 years (1 for L1 and 3 for L2) it is still sooooo frustrating to see poor results after studying for so many months. What are your thoughts on L3 and trying to make the most out of trying to write it only once?

    Look forward to hearing from you. Hope you are enjoying the first spring without the CFA in your life.

  2. hey yellowman! great to hear from you.

    don’t be discouraged by how unprepared you feel. i never felt well-prepared for any of the exams. given the volume of material and the fact that you only remember well what you studied recently, i don’t believe it’s possible to go into a CFA exam feeling like you’re ready.

    the same goes for the practice tests. you can be doing the same test for the 4th time and still only scoring in the 70% range. here was my strategy when it was a few weeks from exam day like it is now:

    (1) I switched solely to doing the 2 volumes of practice tests (6 tests)
    (2) I worked those 6 tests over and over again sequentially
    (3) I didn’t work them as a timed practice exam. I gave myself as much time as I wanted and looked at the answer key after each 6-question vignette. The focus was on REALLY UNDERSTANDING the whys and hows of doing each step correctly.
    (4) If I still didn’t feel like I understood after reviewing the answer key, I’d review the topic in the SchweserNotes and maybe work a couple of the problems there too. So the mindset was, if I worked a problem and missed it, I did what I thought was necessary to make sure I’d never miss that type of question again.
    (5) Regardless of (4) some problems or topics are just plain tricky and you keep making mistakes. Put an example of those on index cards so that you can review them periodically.

    Most important is just to keep studying and ignore emotions. What one man can do, another can do – and the only way you don’t get through the program is if you quit.

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