The strengths and weaknesses of DCF stock valuation
Beginner Stock Market Investing, Stock Market Investing Advice, Stock Valuation
Time and again, you would have heard it said that one of the best ways of valuing a company or a business is to use cash as a measure. Cash is a hard number that is completely factual and cannot be manipulated or influenced by dodey accounting techniques. This is undoubtedly true but it is important to have a proper picture of the strengths and weaknesses of valuation methods based on discounted cash flows. In this way you can benefit from the positive factors while being aware of the limitations imposed by the negative factors.
One of the most important strengths of DCF valuation is that it is probably the valuation technique that provides the most accurate estimate of the intrinsic value of the stock. Other popular valuation methods based on relative valuation are much easier to calculate and implement than DCF valuations. There are major limitations in that they are not very helpful if an entire industry or business sector is over valued or undervalued. This makes it extremely difficult to establish the growth and investment potential of any stock in one of these sectors.
On the other hand, a DCF valuation that is put together carefully will solve this under and over valuation conundrum because it produces a fair value figure on the stock which can be used as the basis for decision making. Free cash flows, on which DCF valuation techniques rely, are reliable measurements unlike earnings which are most vulnerable to manipulation and accounting jugglery. The calculation of free cash flow is not affected whether, for instance, an outflow of cash is expensed on the profit and loss account or capitalized as an asset on the balance sheet.
The other major advantage of the DCF technique is that instead of going to the trouble of a fair value for the stock, you can simply take the current market value and work out what kind of growth is required to justify this price. If it turns out to be a low growth rate that the company can easily achieve, you are almost certainly looking at a good investment.
The major drawback in the DCF valuation technique is that it is totally dependent on the assumptions that are made for the inputs. The value can fluctuate widely depending on the accuracy of these inputs. In other words, the ruling principle is GIGO [Garbage in Garbage out] and if the inputs are rubbish, so will the results be. Even minor inaccuracies at the start of the calculation can be magnified out of all proportion during the last few years of the calculation. As a result, it is not easy to generate a valuation that can be used as a trustworthy basis for investment.
Any DCF model is at its most vulnerable in the areas of prediction of growth as well as the choice of the discount rate. Just take any standard DCF valuation and reduce or increase the cash flow growth rate by 1%. There will be a dramatic impact on the resulting valuation. Similarly, adjust the discount rate by 1% both upwards and downwards and you would be able to see for your self how the resulting valuation is affected.
Tags: DCF, discounted cash flow, Investing, Stock Market, stock market advice, stock market for beginners, Stock Market Investing, stock valuation