Why Buffett stocks "defy" EMH

[Graham Osborn]

In case anyone finds this interesting, I did a simulation illustrating why Buffett defies the efficient market hypothesis.  Even if one knew the future free cash flows of Company X precisely, the intrinsic value of the company according to a DCF analysis fluctuates over time.  Therefore, if one buys a company where the future free cash flows can be predicted to increase for a number of years, the stock should rise significantly over the coming years even when all information has been discounted, as the graph shows.  One can also see that once FCF stops growing, intrinsic value will stop growing as well.  The decline in intrinsic value shown here would only happen if the company started dying, which many companies do sooner or later if they are too big to be acquired.

DCF_simulation.xlsx

[rb]

Maybe I'm missing something here, but what does this have to do with EMH vs Buffett?

[constructive]

A company which grows at 15% per year for 21 years and then 0% afterwards does not deserve a constant 15% discount rate. It deserves a discount rate that varies over time.

[Graham Osborn]

Maybe I'm missing something here, but what does this have to do with EMH vs Buffett?

 

People often phrase EMH as "all the info is already priced in," meaning TRs like Buffett's are a statistical anamoly.  Of course not everyone thinks this since EMH is really a spectrum of theories depending on input parameters.  But the concept is that intrinsic value can logically and consistently increase even in a world of perfect foresight re cash flows.

[Graham Osborn]

A company which grows at 15% per year for 21 years and then 0% afterwards does not deserve a constant 15% discount rate. It deserves a discount rate that varies over time.

 

We could debate the discount rate, but it isn't really the point of the calculation.  I think we can agree a discount rate of 15% is above average.  The general trend of the graph would actually be accentuated if you had lower discount rates some years.  If you want to adjust that in the spreadsheet to what you think it should be I'd certainly be interested to view the result.

[writser]

Yes, if you imagine a company that stops growing in 2038 (and stops earning money after 2060) and discount all cashflows at 15% you will get a graph that goes up and then down. That is just basic math and has nothing to do with disproving the EMH. It just proves that you don't seem to understand the logical implications of stuffing some values in a DCF model.

 

Think about this: your company is worth 315m in 2018 in 2018 dollars. But what's the value of a 2018 dollar in 2017 if you use a discount rate of 15%?