Most finance courses espouse the gospel of discounted cash flow (DCF) analysis as the preferred valuation methodology for all cash flow generating assets. In theory (and in college final examinations), this technique works great. In practice, DCF can be difficult to apply in the valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are useful to help generate a complete valuation picture of a stock. (For more background, read Taking Stock Of Discounted Cash Flow.)

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Basics of DCF Analysis
DCF theory holds that the value of all cash flow generating assets - from fixed-income to investments to an entire company - is the present value of the expected cash flow stream given some appropriate discount rate. The formula for this is usually given something like this:

PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)n-1

Where:

PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year

For equity valuation, analysts most often use some form of free cash flow for the valuation model cash flows. FCF is usually calculated as operating cash flow less capital expenditures. Note that the PV has to be divided by the current number of shares outstanding to arrive at a per share valuation. Sometimes analysts will use an adjusted unlevered free cash flow to calculate a present value of cash flows to all firm stakeholders. They will then subtract the current value of claims senior to equity to calculate the equity DCF value and arrive at an equity value. (For more insight, read Taking Stock Of Discounted Cash Flow and Discounted Cash Flow Analysis.)

Problems with DCF

  1. Operating Cash Flow Projections
    The first and most important factor in calculating the DCF value of a stock is estimating the series of operating cash flow projections. There are a number of inherent problems with earnings and cash flow forecasting that can generate problems with DCF analysis. The most prevalent is that the uncertainty with cash flow projection increases for each year in the forecast - and DCF models often use five or even 10 years' worth of estimates. The "out" years of the model can be total shots in the dark. Analysts may have a good idea of what operating cash flow will be for the current year and the following year, but beyond that, the ability to project earnings and cash flow diminishes rapidly. To make matters worse, cash flow projections in any given year will most likely be based largely on results for the preceding years. Small, erroneous assumptions in the first couple years of a model can amplify variances in operating cash flow projections in the later years of the model. (To learn more, check out Style Matters In Financial Modeling.)
  2. Capital Expenditure Projections
    Free cash flow projection involves projecting capital expenditures for each model year. Again, the degree of uncertainty increases with each additional year in the model. Capital expenditures can be largely discretionary; in a down year, a company's management may rein in capital expenditure plans (the inverse may also be true). Capital expenditure assumptions are, therefore, usually quite risky. While there are a number of techniques to calculate capital expenditures, such as using fixed asset turnover ratios or even a percentage of revenues method, small changes in model assumptions can widely affect the result of the DCF calculation.
  1. Discount Rate and Growth Rate
    Perhaps the most contentious assumptions in a DCF model are the discount rate and growth rate assumptions. There are many ways to approach the discount rate in an equity DCF model. Analysts might use the Markowitzian R = Rf + β(Rm - Rf) or maybe the weighted average cost of capital of the firm as the discount rate in the DCF model. Both approaches are quite theoretical and may not work well in real world investing applications. Other investors may choose to use an arbitrary standard hurdle rate to evaluate all equity investments. In this way, all investments are evaluated against each other on the same footing. When choosing a method to estimate the discount rate, there are typically no surefire (or easy) answers. (For more on calculating the discount rate, see Investors Need A Good WACC.)

    Perhaps the biggest problem with growth rate assumptions is when they are used as a perpetual growth rate assumption. Assuming that anything will hold in perpetuity is highly theoretical. Many analysts contend that all going concern companies mature in such a way that their sustainable growth rates will gravitate toward the long-term rate of economic growth in the long run. It is therefore common to see a long-term growth rate assumption of around 4%, based on the long-term track record of economic growth in the United States. In addition, a company's growth rate will change, sometimes dramatically, from year to year or even decade to decade. Seldom does a growth rate gravitate to a mature company growth rate and then sit there forever.

Due to the nature of DCF calculation, the method is extremely sensitive to small changes in the discount rate and the growth rate assumption. For example, assume that an analyst projects company X's free cash flow as follows:

In this case, given standard DCF methodology, a 12% discount rate and a 4% terminal growth rate generates a per-share valuation of $12.73. Changing only the discount rate to 10% and leaving all other variables the same, the value is $16.21. That's a 27% change based on a 200 basis point change in the discount rate.

Alternative Methodologies
Even if one believes that DCF is the be-all and end-all in assessing the value of an equity investment, it is very useful to supplement the approach with multiple-based target price approaches. If you are going to project income and cash flows, it is easy to use the supplementary approaches. It is important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on the company's history and its sector. Choosing a target multiple range is where it gets tricky.

While this is analogous to arbitrary discount rate selection, by using a trailing earnings number two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer assumptions to "value" the stock than under the DCF scenario. This improves the reliability of the conclusion relative to the DCF approach. Because we know what a company's P/E or price/cash flow multiple is after every trade, we have a lot of historical data from which to assess the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical and we do not really have any historical data to draw from when calculating it.

Be Open Minded
As an investor, it's wise to avoid being too reliant on one method over another when assessing the value of stocks. While most investors probably agree that the value of a stock is related to the present value of the future stream of free cash flow, the DCF approach can be difficult to apply in real-world scenarios. Supplementing the approach with multiple based target price approaches is useful in developing a full understanding of the value of a stock.

For related reading, see Relative Valuation: Don't Get Trapped.

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