Many sophisticated share market investors hail DCF (Discounted Cash Flow) Models as the one and only way to estimate the true intrinsic value of a company.  For them, it is indeed the crown jewel of valuation techniques.

Other investors, most notably technical analysts, scoff at DCF models as nothing more than complex smoke and mirrors, using contemporary computing power to produce results with no more value than the alchemy formulas or black magic rituals of old.

The truth is, valuation has always been and will always be more of an art than a science.  The technicians are correct when they attack any valuation methodology because they rely on assumptions that may be faulty and estimates that may not come true.

Very few market analysts correctly predicted the collapse of global financial markets in 2008 and the resultant decline in share prices the world over.  Natural disasters like the recent earthquakes in New Zealand and Japan and the flooding in Australia seem to be occurring with an alarming frequency.

Events like these appear to be making momentum trading and other short-term investing strategies increasingly popular among retail investors.  However, if you believe there is still order in the world that balances out in the long term, valuation methodologies remain critically important.

 

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You probably already know that valuation based on reported earnings and estimates of future earnings are not the favorite tools of many financial experts.  Skilled accountants can often make earnings appear far better than they actually are.  Because of this, many experts prefer cash flow ratios, since it is not easy to manipulate the numbers reflecting the flow of cash within a company.

However, even the favored Price to Cash Flow (P/CF) Ratio and its cash flow cousins suffer from a major disadvantage – future cash will be worth less than current cash.  The time value of money is a financial concept easily explained.  If you put $1,000 in cash under your mattress and retrieved it in 3 years or 5 years it would not have the same value it did when you originally hid it away.

The core concept underlying DCF models is that the fair value of a share must reflect estimated future cash flows, discounted to present value.  The principle behind DCF analysis has been around for a long time but did not become an accepted analytical tool until contemporary computing power made the complex calculations possible.

As a retail investor, you should have a general understanding of what a DCF fair value estimate means as well as its advantages and disadvantage.  Serious investors read professional share analyst reports and many analysts use DCF models to determine their estimated fair value price for the shares.

If you find an analyst report that indicates the shares of a company in which you have an interest have a fair value of $15 per share, what does that mean to you?  Well, if the shares are currently trading at $10 or $7.5, it may mean the company is a solid long-term investment.

However, there are different DCF models that analysts use, including the DDM (Dividend Discount Model) and Free Cash Flow to Equity (FCFM).  There are also different approaches to discounting the future cash flows, with the most common being the WACC (Weighted Average Cost of Capital).  In short, you have to know how the analyst who prepared the report calculated the number.

Most good professional financial analysts will detail the methods they used, their underlying assumptions, and the basis for their estimates and projections.  Although many newcomers to share market-investing take what they read at face value, the more experienced you become the easier it is for you to evaluate the soundness of the analyst’s conclusions.  DCF models are classic examples of the old information technology acronym – GIGO (Garbage In, Garbage Out).

Analysts who feed garbage into their models produce garbage results, which a more experienced investor can smell.  Questioning the inputs an analyst plugs into the DCF model often requires an advanced understanding of the nature of the business in which the company operates and its market.

Such experience comes in time, but in the beginning of your investing career, you have another option.  You can look into the track record of the analyst who prepared the report.  The Thompson/Reuters Company has a subsidiary called Starmine that actually rates analyst performance.

Another significant disadvantage of DCF models, ironically enough, is the drawback of what is also their greatest strength – time value.  If there is a time value to money, there is even more of a time value to information.  The assumptions used in a DCF model are based on information that can change dramatically and quickly.  If new competition arises out of nowhere, the estimates of future cash flow may suffer.  Consequently, if you rely on fair value estimates through DCF values, you need to follow an analyst who monitors the shares on a regular, even a daily, basis.

The final disadvantage of DCF analysis is its long-term nature.  It can take years before a projected fair value share price is reached, making DCF Models not suitable for investors interested in short term trading.

If you assume the accuracy of the projections and the discounting method employed, it is hard to deny the advantage of gauging the future value of a share in current dollars.  In addition, DCF models come closer to finding the intrinsic value of a company than any other valuation method.  DCF analysis looks at the internals of the company, without the impact of share-market.  Price earnings ratios and Price to Cash Flow ratios can reflect what is going on in the market as a whole.  In raging bull markets, the “irrational exuberance” of investors leads to all shares being over-valued.  The former Chairman of the United States Federal Reserve Board, Alan Greenspan, used that term to describe the dot com bull market of the late 1990s.

Despite its advantages, DCF models are really not tools for the average retail investor.  Yes, you will find websites that walk you through the process of using Excel Spreadsheets to calculate DCF on your own, but the expertise needed to make the projections and assumptions needed are far beyond the capability of even experienced retail investors.

Leave the calculation to the professionals.

 

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