Examining the DCF method of stock valuation
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
This is a time when the financial statements of companies are under closer scrutiny than ever because of a variety of reasons. The choice of the method that you use to value a company and its stock has become increasingly important. The situation has been greatly complicated by a series of scandals concerning company accounting some of which have been downright fraud at the expense of the investing public. Because of the increased distrust of metrics such as P/E ratios and the quality of earnings forecasts, investors are increasingly turning to free cash flow because they believe that this is a figure that is more difficult to manipulate.
They are increasingly using discounted cash flows to establish the present value of a company based on future cash flows. DCF’s are difficult to calculate when compared to other standard valuation methods and require a lot more work. In return for all this effort, however, the investor is rewarded with a more accurate picture of a company. Moreover, because cash flow is a transparent metric, aggressive accounting tactics will not distort this figure.
If you study DCF techniques, you will notice that the biggest influences on share prices are long-term growth rates. Changes in interest rates can also have a substantial influence. You can try and work this out for yourself. Take any information from a standard DCF model and reduce the growth rate assumption. You would probably be surprised by the reduction in the share valuation. You will also see a substantial negative impact on the valuation if you increase the interest rate that has been assumed.
An advantage of using DCF valuations is that you can avoid the problems associated with establishing a target price for the stock. Instead you can work backwards from the current market price to see what kind growth rate the company needs to experience in order to justify the current market value. If this growth rate is low, you are looking at a good investment because the price incorporates a lower growth rate and if a higher growth rate is achieved, the price is bound to go up.
Probably the biggest advantage of using DCF valuation is that you are actually establishing an inherent and intrinsic fair value for the stock. Other valuation methods such as ratio-based methods tend to facilitate comparisons between different stocks rather than establish an absolute fair value. This means that if the different stocks that you are comparing are all overpriced in relationship to their intrinsic value, you will end up picking an overpriced stock no matter what you choose with the prospect of future losses.
With all these advantages, you should not overlook the drawbacks of DCF valuation. The process is mechanical and any erroneous or inaccurate data in the input could affect the valuation disproportionately. You must therefore constantly question the assumptions that you’re feeding into your DCF model. Moreover, DCF valuation is suitable for evaluating long-term investment but is not really suitable for short-term investment.
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