Discounted cash flow: Better to be roughly right than precisely wrong

The importance and greater relevance of looking at cash flows rather than earnings.

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While we perpetually try to improve our investment process – continually seeking to incorporate new learnings and fresh perspectives – one thing will always remain axiomatic: the worth of any financial asset is the present value of its future cash flows. 

As such, our investment effort can be summarised as an ongoing attempt to value equities and try to buy them at a discount. Because we regard stocks as shares of businesses, not numbers that bounce around on a screen, our approach to fractional ownership is no different to private equity and industrial buyers purchasing whole businesses based on the expected cash flows they can extract.

Investment is most intelligent when it is most business-like
Benjamin Graham

Our focus is the future free cash flow produced by a firm, while investing sufficiently to sustain its long-term competitive position, discounted to today’s value at an appropriate rate. We make various adjustments to the historical statements, including normalising cyclical margins, smoothing investment programmes, treating ‘non-cash’ stock-based compensation as an economic expense, and adding-back recurring ‘one-off’ costs. The numbers we arrive at are subjective, and would never be recognised by any accountant; yet the crucial importance of intrinsic value is not diminished by our inability to calculate it precisely.

Here, we part ways with most of the active fund management world. Building a discounted cash flow (DCF) forecast is rigorous. It involves making predictions about an inherently uncertain future based on incomplete evidence while maintaining coherent assumptions about growth and returns. Faced with this complexity, many fund managers fall back on the deceptive certainty of third-party earnings forecasts and relative profit multiples. 

Corporate results press releases typically display an adjusted earnings-per-share figure prominently but leave the cashflow statement to the final page, if it gets mentioned at all. Sell-side analysts working for investment banks tend to take these earnings, extrapolate them out two years, and divide through the current share price to arrive at a price-earnings (P/E) ratio. Thus, company A might be on 16 times earnings, making it apparently cheap against peer company B on 20 times because it usually trades on the same multiple, and therefore becomes a recommended purchase with 25 percent upside. However, all a P/E ratio achieves is to collapse the assumptions a DCF makes explicit.  Hiding from the investment conundrum cannot substitute for addressing the propensity of earnings to convert to cash, future business trajectory, and what prospective return might accrue to long-term equity holders.

Key risks

For further information on the risks and risk profiles of our funds, please refer to the relevant KIID and Prospectus.

The value of an investment and any income from it can go down as well as up and can fluctuate in response to changes in currency exchange rates. Investors may not get back the original amount invested.

Emerging markets risk

The fund invests in emerging markets; these markets may be volatile and carry higher risk than developed markets.

Derivatives risk

The fund uses derivatives; these can be complex and highly volatile. Derivatives may not perform as expected, which means the fund may suffer significant losses.

Illiquid securities risk

Certain assets held in the fund could, by nature, be hard to value or to sell at a desired time or at a price considered to be fair (especially in large quantities), and as a result their prices could be very volatile.

Concentration risk

The fund invests in a small portfolio of securities. Losses from a single investment may be more detrimental to the overall fund performance than if a larger number of investments were made.

Global equities in focus

Global Equity Endurance Fund

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Important information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (“Aviva Investors”) as at November 2019. Unless stated otherwise any opinions expressed are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. 

Past performance is not a guide to future performance. 

The Prospectus and Key Investor Information Document (KIID), are available, together with the Report and Accounts of the SICAV, free of charge from Aviva Investors Luxembourg, 2 rue du Fort Bourbon 1st Floor.L-1249 Luxembourg, Grand Duchy of Luxembourg R.C.S. Luxembourg B25708, Aviva Investors, St Helen’s, 1 Undershaft, London EC3P 3DQ The Prospectus is available in English and German. Where a sub fund of the SICAV is registered for public distribution in a jurisdiction, a KIID in the official language of that jurisdiction will be available.

Issued by Aviva Investors Global Services Limited, the Investment Manager to the Fund registered in England No. 1151805.  Registered Office: St Helens, 1 Undershaft, London, EC3P 3DQ.  Authorised and regulated by the Financial Conduct Authority (Firm Reference No. 1191780).