At a time when loss-making startups are getting listed, the choice of what metric should be used for making company valuations has become increasingly important. A key valuation tool at investors’ disposal is discounted cash flow (DCF) analysis. Analysts use DCF to determine a company’s current value according to its estimated future cash flows. Forecasted free cash flows (operating profit + depreciation – capital expenditures – change in working capital) are discounted to a present value using the company’s weighted average costs of capital.
For investors keen on gaining insights on what drives share value, few tools can rival DCF analysis. Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF more importance. With heightened concerns over the quality of earnings and reliability of standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which offers a more transparent metric for gauging performance than earnings does. It is harder to fool the cash register.
Developing a DCF model demands a lot more work than simply dividing the share price by earnings or sales. But, in return for the effort, investors get a good picture of the key drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, and expected duration of growth. An added bonus is that DCF is less likely to be manipulated by aggressive accounting practices. DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Interest rate changes also make a big difference. Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better–less growth has therefore already been “priced into” the stock.
Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona-fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based valuation acts (P/E etc.) more like a beauty contest: stocks are compared to each other rather than judged on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end up holding a stock with a share price ready for a fall. A well-designed DCF model should, by contrast, keep investors out of stocks that look cheap only against expensive peers.
DCF models are powerful but they do have shortcomings. They are mechanical valuation tool, where small changes in inputs can result in large changes in the value of a company. Meaningful valuations depend on the user’s ability to make solid cash flow projections. While forecasting cash flows more than a few years into the future is difficult, crafting results into eternity (which is a necessary input) is near impossible.
Further, with its focus on long-range investing, the DCF model isn’t suited for short-term investments. If a model throws out a figure, does not mean that the share will trade at that figure any time soon.
Don’t base your decision to buy a stock solely on the DCF model as it’s a moving target, full of challenges. But, it’s the best available amongst all other valuation tools.
Milan Sangani Milan is a veteran stock market investor and educator on equity investing. Connect with him on firstname.lastname@example.org