By Ben McClure
Having worked our way through the mechanics of discounted cash flow analysis, it is worth our while to examine the method's strengths and weaknesses. There is a lot to like about the valuation tool, but there are also reasons to be cautious about it.
Arguably the best reason to like DCF is that it produces the closest thing to an intrinsic stock value. The alternatives to DCF are relative valuation measures, which use multiples to compare stocks within a sector. While relative valuation metrics such as price-earnings (P/E), EV/EBITDA and price-to-sales ratios are fairly simple to calculate, they aren't very useful if an entire sector or market is over or undervalued. A carefully designed DCF, by contrast, should help investors steer clear of companies that look inexpensive against expensive peers. (To learn more, see Relative Valuation: Don't Get Trapped.)
Unlike standard valuation tools such as the P/E ratio, DCF relies on free cash flows. For the most part, free cash flow is a trustworthy measure that cuts through much of the arbitrariness and "guesstimates" involved in reported earnings. Regardless of whether a cash outlay is counted as an expense or turned into an asset on the balance sheet, free cash flow tracks the money left over for investors.
Best of all, you can also apply the DCF model as a sanity check. Instead of trying to come up with a fair value stock price, you can plug the company's current stock price into the DCF model and, working backwards, calculate how quickly the company would have to grow its cash flows to achieve the stock price. DCF analysis can help investors identify where the company's value is coming from and whether or not its current share price is justified.
Although DCF analysis certainly has its merits, it also has its share of shortcomings. For starters, the DCF model is only as good as its input assumptions. Depending on what you believe about how a company will operate and how the market will unfold, DCF valuations can fluctuate wildly. If your inputs - free cash flow forecasts, discount rates and perpetuity growth rates - are wide of the mark, the fair value generated for the company won't be accurate, and it won't be useful when assessing stock prices. Following the "garbage in, garbage out" principle, if the inputs into the model are "garbage", then the output will be similar.
DCF works best when there is a high degree of confidence about future cash flows. But things can get tricky when a company's operations lack what analysts call "visibility" - that is, when it's difficult to predict sales and cost trends with much certainty. While forecasting cash flows a few years into the future is hard enough, pushing results into eternity (which is a necessary input) is nearly impossible. The investor's ability to make good forward-looking projections is critical - and that's why DCF is susceptible to error.
Valuations are particularly sensitive to assumptions about the perpetuity growth rates and discount rates. Our Widget Company model assumed a cash flow perpetuity growth rate of 4%. Cut that growth to 3%, and the Widget Company's fair value falls from $215.3 million to $190.2 million; lift the growth to 5% and the value climbs to $248.7 million. Likewise, raising the 11% discount rate by 1% pushes the valuation down to $182.7 million, while a 1% drop boosts the Widget Company's value to $258.9 million.
DCF analysis is a moving target that demands constant vigilance and modification. A DCF model is never built in stone. If the Widget Company delivers disappointing quarterly results, if its major customer files for bankruptcy, or if interest rates take a dramatic turn, you will need to adjust your inputs and assumptions. If any time expectations change, the fair value will change.
That's not the only problem. The model is not suited to short-term investing. DCF focuses on long-term value. Just because your DCF model produces a fair value of $215.3 million that does not mean that the company will trade for that any time soon. A well-crafted DCF may help you avoid buying into a bubble, but it may also make you miss short-term share price run-ups that can be profitable. Moreover, focusing too much on the DCF may cause you to overlook unusual opportunities. For example, Microsoft seemed very expensive back in 1995, but its ability to dominate the software market made it an industry powerhouse and an investor's dream soon after.
DCF is a rigorous valuation approach that can focus your mind on the right issues, help you see the risk and help you separate winning stocks from losers. But bear in mind that while the DCF technique we've sketched out can help reduce uncertainty, it won't make it disappear.
What's clear is that investors should be conservative about their inputs and should not resist changing them when needed. Aggressive assumptions can lead to inflated values and cause you to pay too much for a stock. The best way forward is to examine valuation from a variety of perspectives. If the company looks inexpensive from all of them, chances are better that you have found a bargain.
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