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Model Choice
Considerations | Guidelines | Questionnaire | Patterns
Considerations for Model Choice
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The heart of an investment valuation model is a forecasting model which is just as much a part of the forecast as are the other assumptions such as the base period amount and the growth rate. In some cases the investment valuation model is a crucial assumption.
Choose the investment model with the forecasting model that best conforms to your expectations of the future pattern and speculativeness of growth. Where warranted, a second investment model can be used for independent confirmation.
Different investment models can lead to the same intrinsic value.
Each intrinsic value model can return the same value or same mean value for innumerable combinations of input data. Likewise, for each of the rate of return models and the implied growth model. In addition, all models that calculate value or mean value are equivalent in the sense that appropriate combinations of input data for each model can return the same value, whether a single point or the mean of a range, as returned for the other intrinsic value models, each with its appropriate combinations of input data. Likewise, for the models that calculate rate of return. Thus, any investment model can work in almost any situation if the combination of input data is appropriate to that particular model.
These investment models serve as a qualitative aid to decision-making (buy, sell, hold or pass) rather than as a precise measure of value.
Guidelines for Model Choice
Growth
RateGrowth
PatternRate and PATTERN Relationship
Slower
Smooth Infinite Duration
Growth rate lower than the risk-free discount rate.
Moderate
Smooth Finite Duration
Growth rates remaining after eliminating slower and faster growth rates.
Faster
Abrupt Finite Duration
Abrupt change from slower to faster or from faster to slower rates includes non-sustained faster rate.
Speculative
Implied Smooth Finite Duration
Less than six years of history and unprecedented or sustained faster growth rates.
Questionnaire Choice of Model
This is a verbal algorithm, but don't let that mystify you. An algorithm is any special method of solving a certain kind of problem.
The investment time horizon, or intended holding period, is expected to be long term for most value investing situations. Some exceptions are resource conversions such as risk arbitrage (three to six months) and workouts (three to five years). If the horizon is less than five years, then use a General DCF model.
Dividends are expected to be positive. Dividends are negative when they exceed earnings in the period. If negative future cash dividends are expected, then use a General DCF model.
The growth in free cash flow to common stock equity is expected to be well approximated by a regular pattern such as exponential (compound annual) increase. If no such growth pattern is expected, then use a General DCF model.
The opportunity cost discount rate is expected to be invariant for the investment time horizon. If no such constant discount rate is expected, then use a General DCF model.
Otherwise, you may choose an appropriate model with a suitable future growth pattern by answering the following questions.
Question 1 : Annuity
Are you valuing an annuity contract as opposed to a common stock?
YES: Use the Value 1-Stage Annuity model. If evaluating a composite (multiple-stage) annuity, use this model for each stage and add the values for each to derive an annuity total. If a stage is longer than 20 years duration, divide it into sub-stages and add the values for each to derive a total for that stage. The Value 1-Stage model was not designed primarily for inflation-adjusted real-value annuities, and the input data for them can be tricky. Go to the END.
NO: Go to Question 2.
Question 2 : Return
Do you want to estimate rate of return instead of intrinsic value?
YES: Go to Question 6 A
NO: Go to Question 3.
Question 3 : Speculativeness
Do you expect the future growth of the subject company to be highly speculative in the sense of sustained high rates as opposed to more well-established growth rates? In general, a company without at least seven full fiscal years of audited financial history may be considered speculative. As a benchmark, growth of 20% per year for 20 years is unprecedented
YES: Use the Value Goal 1-Stage model. Go to the END.
NO: Go to Question 4.
Question 4 : Duration
Do you expect the future growth of the subject company to be evaluated over an indefinitely long or infinite investment horizon with no terminal sale instead of a finite duration, and is the expected growth rate smaller than the expected discount rate?
YES: Use the Value S-Curve model. Go to the END.
NO: Go to Question 5.
Question 5 : Predictability
Do you expect the future growth of the subject company to be fairly predictable instead of highly unpredictable over a wide range of outcome scenarios?
YES: Use one of the Value models. Go to Question 6 B.
NO: Use one of the Value Range models. Go to Question 6 C.
Question 6 A : Smoothness
Do you expect the future growth of the subject company to be continuously smooth as opposed to having an abrupt change? An abrupt change indicates a transition of either faster-then-slower or slower-then-faster growth.
YES: Use the Return 1-Stage model. Go to the END.
NO: Use the Return 2-Stage model. Go to the END.
Question 6 B : Smoothness
Do you expect the future growth of the subject company to be continuously smooth as opposed to having an abrupt change? An abrupt change indicates a transition of either faster-then-slower or slower-then-faster growth.
YES: Use the Value 1-Stage model. Go to the END.
NO: Use the Value 2-Stage model. Go to the END.
Question 6 C : Smoothness
Do you expect the future growth of the subject company to be continuously smooth as opposed to having an abrupt change? An abrupt change indicates a transition of either faster-then-slower or slower-then-faster growth.
YES: Use the Value Range 1-Stage model. Go to the END.
NO: Use the Value Range 2-Stage model. Go to the END.
Questionnaire END. Congratulations.
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Future-Growth Patterns
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Level
Decline
Slower
Faster
Abrupt
S-Curve
Annual Constant
Annual Variable
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