Thursday, October 13, 2016

Finance In One Sentence: Time Is Money Edition

This is also an early contender for the coveted Climateer Line of the Day award:

"Discounting = putting a price on time = very important/ central to finance."

That's from David Keohane at FT Alphaville in:

Bernstein questions foundation of finance. Again.
Bernstein, having tried to slap down passive investing as the road to serfdom, has now set itself against DCF models in a zero rate world.

DCF model = discounted cash flow model.

Discounting = putting a price on time = very important/ central to finance.

Thing is though, this low rate world of ours is maybe messing everything up.

As Bernstein’s Inigo Fraser-Jenkins and team put it, if it is not possible to put a “price on time” then there is a genuinely intellectually painful environment where model structure is called into question:
The problem is that [DCF models] were invented and historically used in a world where risk free rates averaged 5% or more. In a world where the risk free rate is close to zero then the errors in such models explode.
Specifically, if the overall discount rate (WACC) falls from 10% to 5% in a very simple DCF then the proportion of the net present value accounted for by cash flows more than 5 years in the future rises from 70% to 95%. How far in the future can any analyst forecast? We would suggest that any human’s ability to forecast financial variables more than about 5 years in the future is limited at best. At the very least small errors at that forecasting horizon become very significant.
As Bernstein admit, it has always been know that DCF models put a larger than ideal weight on uncertain cash flows that run far into the future. It’s just that the problem is now more intense....MORE
Possibly also of interest:

"Goldman Sachs Says It May Be Forced to Fundamentally Question How Capitalism Is Working"
Goldman Sachs: Death Of Capitalism Averted, Time For Working Schlubs to Partaay!