Read this in Money Stuff this morning. Thought some of you might get a kick out of it.
What even is a DCF?
Morgan Stanley initiated equity research coverage on Snap Inc. last week with a $28 price target, based on a discounted cash flow model. The next day, though, it realized that the cash flows it was discounting were wrong, as Matt Turner and Rachael Levy report. It had made "a tax calculation error" that overstated earnings in the later years of its model; in 2025, for instance, it had projected almost $4.1 billion of free cash flow, but when it fixed the calculation it projected only $2.4 billion of cash flow. So it put out a new report with those numbers corrected and a ... $28 price target. Hmm! Apparently the original report didn't just get the cash flows wrong; it also had an offsetting error in the discount rate:
We have also corrected our discounted cash flow calculation so that it is consistent and comparable across our US internet coverage. More specifically, we are lowering our SNAP equity risk premium from 5.59% (an estimated pre-IPO rate) to 4.29% (consistent with other companies in our group). This change lowers our WACC to 8% (from 10%). On an aggregate basis, our price target is unchanged at $28/share.
Snap's cash flows were lower than they had thought, but its weighted average cost of capital was also lower than they had thought, so no harm no foul. Hmm!
"It almost feels that they're backing into the numbers," said Charles Lee, a professor at the Stanford Graduate School of Business. "It just so happens that the two work out so that they don't have to change their price target.
"It's almost humorous," Lee added.
Turner and Levy point out that other banks who worked on Snap's initial public offering and published research reports used higher WACCs than Morgan Stanley, though they got pretty similar price targets. Hmm!
Look, I am going to say some upsetting things in this paragraph, and you may want to avert your eyes. But one obvious point is that Morgan Stanley was not "wrong" to say that Snap's free cash flow would be $4.1 billion in 2025, and it was not "right" to change that number to $2.4 billion. Morgan Stanley has no idea what Snap's free cash flow will be in eight years. Snap has only existed for about five years, and its free cash flow in 2016 was negative $709 million. Estimating its free cash flow in 2025 is not primarily a problem of getting the tax calculations right. Snap is worth what people will pay for it, and there is an accepted arithmetic relationship between price and discounted cash flows, and so if people will pay $X for it you can build a discounted cash flow model that produces $X. (Or some other number anchored on $X.) And if you find an error in your model, correcting the error and revising your price target is in some crude but obvious sense the wrong reaction. Your model made sense mainly because its output made sense. If you find an error that messes up that output, you'd better go find another error to offset it.
TL;DR Morgan Stanley fucked up their DCF model projecting Snap's FCF, found a more conservative number, plugged it into the model, and... nothing. Same price target of $28. They conveniently remembered to adjust the cost of capital down. Talk about fitting a model to a price target.
Submitted April 05, 2017 at 10:03AM by isrly_eder http://ift.tt/2oIhl1R
