Recently, I read (and re-read) several books and other content about our biases and how these affect our investing decisions (mostly negatively). Over-confidence is one of the very common biases. My learnings about biases motivated me to revisit my Flow Traders analysis …
In my prior Flow analysis, I estimated Flow’s value based on a scenario-weighted expected value. I used scenarios since its value is very much dependent on a few key value drivers. At least that was and still is my current belief. At the same time, I do not know how these key drivers will develop over the short, mid and long-term. The modeled scenarios, represented four individual paths that could be (randomly) taken today. But switching paths was not possible afterwards.
To tackle my over-donfidence I introduced some randomness into my valuation model. My first approach, was to define five scenario-states per key driver per year until 2030. Then I performed a monte carlo simulation or rolled the dice and recorded the output (fair value estimates). This was already very helpful, illustrating (below) the randomness, uncertainty, range of likely outcomes and helped me Thinking in Bets. My results indicated a significant undervaluation for the majority of cases, mean and median, triggering the questions if I trust my own results and assumptions.
Next, I refined my approach and introduced probability distributions for each key driver per year to incorporate continuous random variables (key drivers) and changed the random variable market share to market share gains, to prevent erratic changes from market share from one year to the next.
My investment decision: Overall, I trust my model and my valuations estimates as being good enough. Despite the indicated undervaluation, I will likely wait for lower prices when the odds are even more in my favour. This should be the case when earnings are cyclically depressed by lower volatility. >> Please click here for my Flow Traders write-up (pdf).
What are your learnings from such modelling? Important learnings or disregarded as a waste of time?