The three main challenges of applying discounted cash flow analysis

Finance courses commonly advocate the use of discounted cash flow (DCF) analysis as the primary valuation method for assets generating cash flow. While effective in theory, applying DCF to evaluate equities can present challenges in real-world scenarios.

Despite the prominence of DCF, it is beneficial to consider alternative approaches to gain a comprehensive view of stock valuation.

Basics of DCF Analysis

DCF analysis aims to determine a company’s true value by projecting its future earnings. It asserts that the value of cash flow-generating assets, whether stocks or entire companies, is the present value of expected cash flows discounted at the appropriate rate.

Essentially, DCF calculates a company’s current and future available cash, known as free cash flow, derived from operational profit, depreciation, and amortization after deducting expenses. These projected amounts are discounted using the weighted average cost of capital to estimate the current value of the company’s growth prospects.

The typical formula for DCF involves the present value (PV) calculated using cash flows for each period, a discount rate (k), and an assumed growth rate (g) for perpetuity.

When valuing equities, analysts often utilize free cash flow projections in the DCF model. Free cash flow (FCF) is commonly computed as operating cash flow minus capital expenditures.

To determine per-share valuation, the PV must be divided by the current shares outstanding. Analysts may opt for adjusted free cash flow to ascertain the present value of cash flows to stakeholders and then derive an equity value.

In evaluating stocks, a rule of thumb suggests that a stock is appealing if its DCF analysis value exceeds the current share price.

Problems With DCF

Despite its utility, DCF models have limitations, with varying effectiveness across sectors. Several potential pitfalls are associated with relying solely on DCF analyses.

Operating Cash Flow Projections

Estimating a stock’s DCF value hinges on accurately forecasting operating cash flow projections. Challenges arise due to uncertainties in earnings and cash flow predictions, especially as the forecast horizon extends, with later years often being highly unpredictable.

The ability to project earnings diminishes beyond the near term, and small errors in initial assumptions can compound inaccuracies in later periods, emphasizing the critical need for precise projections.

Capital Expenditure Projections

Forecasting free cash flow involves projecting capital expenditures for each model year, with inherent uncertainties escalating as the projection period lengthens. Capital expenditure estimates are often discretionary, leading to increased projection risk in fluctuating economic conditions.

Methodologies for calculating capital expenditures may vary, but slight adjustments in assumptions can significantly impact DCF results.

Discount Rate and Growth Rate

Determining the discount and growth rates in DCF models can pose challenges, with analysts employing diverse approaches that may not always align with real-world investment scenarios.

Selecting appropriate discount rates and perpetual growth rate assumptions involves theoretical considerations, with no definitive or simple solutions. Growth rate assumptions, particularly in perpetuity, are highly speculative and may not hold true indefinitely.

The nature of DCF calculations makes them sensitive to slight adjustments in discount and growth rates, showcasing the necessity for precise inputs to generate accurate valuations.

Even minor modifications in discount and growth rates can significantly impact DCF valuations, underscoring the need for careful consideration of these variables in the analysis.

Alternative Methodologies

Supplementing DCF with multiples-based target price approaches enhances the assessment of equity investments. By incorporating trading multiples based on historical data and sector specifics, investors can gain a more robust understanding of stock value.

Using multiple-based approaches reduces the reliance on assumptions compared to the DCF method, thereby bolstering the reliability of stock valuations based on tangible market data.

The Bottom Line

DCF analysis offers a valuable tool for assessing stock value based on projected free cash flows. While acknowledging its significance, it is essential to acknowledge the limitations and potential inaccuracies that can arise from varying input assumptions.

In practice, DCF analysis may not always be straightforward due to the multiplicity of inputs and the sensitivity of its outcomes to small changes, emphasizing the need for cautious and diversified valuation approaches.

Considering different analyses and methodologies can provide a broader perspective on stock valuation, ensuring a more well-rounded evaluation of investment opportunities.

Investors are encouraged to avoid over-reliance on any single valuation method and to supplement DCF analysis with diverse valuation approaches to enhance decision-making and risk management.