The discounted cash flow approach describes a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values. The discount rate used is generally the appropriate cost of capital and may incorporate judgments of the uncertainty (riskiness) of the future cash flows. But there are several pitfalls which a lot of investors tend to fall into by making investment decisions based on DCF analysis.
The first and most important factor in calculating the DCF value of a stock is estimating the series of operating cash flow projections. There are a number of inherent problems with earnings and cash flow forecasting that can generate problems with DCF analysis. The most prevalent is that the uncertainty with cash flow projection increases for each year in the forecast – and DCF models often use five or even 10 years’ worth of estimates. The “out” years of the model can be total shots in the dark. Analysts may have a good idea of what operating cash flow will be for the current year and the following year, but beyond that, the ability to project earnings and cash flow diminishes rapidly
In a rare book review written on Burr Williams’ “Theory of Investment Value”, Ben Graham summarizes the flaw in DCF as follows:
Clearly, Mr. Williams’ method stands or falls not on his formulas (which are unimpeachable) but on his assumptions with respect to their numerous variables-e.g., the rates of growth, of distribution of profits, and of interest; and the “terminal value” when growth ceases. One wonders whether there may not be too great a discrepancy between the necessarily hit-or-miss character of these assumptions and the highly refined mathematical treatment to which they are subjected.
Indeed, the method is extremely sensitive to small changes in the discount rate and the terminal growth rate assumption. Perhaps the biggest problem with growth rate assumptions is when they are used as a perpetual growth rate assumption. Assuming that anything will hold in perpetuity is highly theoretical.
Ben Graham also provides a specific example on misguided growth assumptions when using DCF:
I was especially interested in the study of Phoenix Insurance to see how Mr. Williams deals with the vexing problem of evaluating an expected long-term upward trend in earnings. The result was rather surprising. The value “assuming growth completed” was set at $105, by what amounts to the quite conventional method of multiplying expected normal earnings by 20. The method of discounting future growth (consuming seven pages and requiring much mathematics) added only $5.00 to this value, because in fine the author arbitrarily limited his consideration to a very minor net gain from an expansion lasting only a few years. The case study of American Telephone in 1930 yields even stranger results. Assuming an annual rate of growth of 10 percent for ten years, the author finds an investment value of $200 per share. But had he assumed no growth at all and valued the 1929 earnings on the same basis as he used for the average earning power of Phoenix Insurance, the value of American Telephone would have been 20 X $14, or $280.
Many academics contend that all going concern companies mature in such a way that their sustainable growth rates will gravitate toward the long-term rate of economic growth in the long run. It would be therefore appropriate to see a long-term growth rate assumption of around 4%, based on the long-term track record of U.S. GDP growth. However, many analysts today tend to use figures exceeding 10 percent for a prolonged period of time when only a few elite companies will be capable of such feat. In addition, a company’s growth rate will change, sometimes dramatically, from year to year or even decade to decade.
While most investors probably agree that the value of a stock is related to the present value of the future stream of free cash flow, the DCF approach is often not realistic. Supplementing the approach with multiple based target price approaches, as Graham demonstrated above with Phoenix Insurance and American Telephone, is useful in developing a full understanding of the true value of a business.