Drawbacks of using DCF for stock valuation
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
Discounted cash flows are often touted as the best method to value any assets that generate cash and this includes stocks. This is fine in theory but DCF can be difficult and complicated when it comes to practical situations. Moreover, using other valuation techniques in combination with DCF will provide a broader picture of a stock being valued.
We all know that the theory of DCF involves calculating the future cash flow from any cash generating assets and then using a discount rate and that appears to be appropriate to establish the present value. When it comes to the valuation of stocks, the most commonly used cash flow figure is what is called free cash flow. This is calculated by reducing the capital expenditure from the operating cash that is generated. The present value divided by the number of shares outstanding will provide the value per share.
The first drawback to using DCF is to produce reasonable and accurate estimates of operating cash flow. Forecasting earnings and cash flows have inherent drawbacks that can interfere with accurate DCF calculations. The uncertainty associated with these forecasts increases as the timeframe for the calculation becomes longer. Because many DCF models use periods that can go up to 10 years, often the forecasts for the last few years are little more than educated guesswork. These forecasts may be reasonably accurate for the current year and the following year but beyond that, the accuracy is bound to be doubtful. To make matters worse, the normal practice is to base the forecast for every year in the future of the results of the immediately preceding year. As a result, even small errors in the first couple of years can cause significant distortions in the following years.
The second problem lies with projecting future capital expenditure realistically. Here again, the longer the timeframe of the prediction, the higher the degree of uncertainty. Capital expenditure is normally made at the discretion of top management and is difficult to predict because it may be cut to combat a business downturn or enhanced to take advantage of favorable business conditions. Even minor inaccuracies can distort the result of the valuation.
Perhaps the most contentious areas of DCF valuation lie in the growth rate and the discount rate that are used. There are many approaches that can be used in establishing a discount rate for instance such as the weighted average cost of capital. Many of these are theoretical and may not work properly in a real-world situation. Some investors actually chose to use an arbitrary rate which they apply to all their equity investments so as to create a standard hurdle rate as a basis for comparison. Unfortunately there is no single correct solution.
With regard to the growth rate, the problem with many approaches is that they regard the growth rate as perpetual and this can be a risky approach in practice. However, supporters of DCF analysis maintain that many well-run companies will tend to have a long-term growth rate that approximates the growth rate of the economy as a whole. It is therefore safe to use the projected long-term growth rate of the economy as a proxy for the growth rate of the company.
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