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Mistakes in Discounted Cash Flow

eduCBA presents…..

Aren’t we hearing about stocks and companies

on television and in newspapers every day?

And what was the daily news that you read?

Yes, it was always about various companies and

how their stocks went high or low.

Want to know how?? Continue reading……

Warren Buffet did not spend

his entire life being scared and

sitting in one corner of Wall

Street. Everyone knows where

he is now!!!

Scared of investing in shares already?

No, you don’t have to.

So now let’s get started on this topic …..

By now you must have a little idea of how financial ratios and multiples are used to analyze a company.

But have you ever thought about how do we go about estimating the absolute value of any company?

That's when discounted cash flow (DCF) method of valuation comes handy.

Coming to

discounted cash

flow approach,

yes, it helps in

determining stock

prices in a

different and

robust way.

For example, if you

estimate a stock is

worth $50 based

on a DCF model,

and it is currently

trading at $80, you

have to know that

it's overvalued!!!

Analysts in big

investment banks

use DCF to

determine

company's current

value according to

its estimated

future cash flows.

But now we come to the main point….

The stock and

the company

that you

invested is at

its all-time low.

You lost your

money.

Wish that you had not done “Mistakes in Discounted Cash Flow”???

So let’s analyze some of the common DCF errors and learn how

not to commit the same!!!

1. Inappropriate Forecast

Horizon!!!

• A time frame of atleast five years needs to be considered while performing DCF analysis.

• But this does not mean that you consider the time frame of 50 years.

• Consider a proper explicit period that is not too short or not too long.

2. Cost of Capital!!!

• The cost of debt part for large companies is usually transparent as they have to make contractual obligations by the way of coupon payments.

• Estimating the cost of equity is more challenging because unlike debt’s explicit cost, the cost of equity is implicit.

The Next Factor Is BETA…..

Beta reflects the sensitivity of a stock’s price movement

relative to the broader market.

A beta below 1 means that the stock moves less than the

market.

While a beta above 1 implies that the stock moves

greater than the market.

Beta, though it sounds wonderful in theory it fails

practically and empirically.

Beta’s empirical failure shows how beta does a poor job

explaining returns.

3. Mismatch between assumed investment and earnings growth…!!!

ROI helps in

determining the

efficiency with

which a

company

translates its

investments

into earnings

growth.

DCF models can

sometimes

underestimate

the investment

necessary to

achieve an

assumed

growth rate.

4. Incorrect consideration of other liabilities.

• Some other liabilities, like employee stock options, are trickier and more difficult to analyze.

• Thus most analysts do a very poor job analyzing these liabilities.

• Hence investors must properly categorize and

recognize other liabilities in the sectors where they may have a large impact on corporate value.

5. Scenario changes

• Sometimes small changes in assumptions can also lead to large changes in the value.

• Investors should also look to the value drivers like sales, margins, and investment needs as sources of variant sensitivity.

6. Double counting the Risk

• Directly adjusting the cash flows in the model or discount rate are the two ways of taking into account the uncertainty of future cash flows.

• Hence if adjustments are made in both the above mentioned methods, it can lead to error.

7. Aggressive terminal growth rate assumptions.

• Generally the long term growth rate assumptions are taken wrong.

• Long-term rate of growth should not exceed the sum of inflation and real GDP growth at the most.

Some other types of Mistakes are…..

• Incorrect matching of real and nominal cash flows and discount rates.

• Failure to recognize "Typical" market conditions

• Errors in predicting the Tax rate.

Conclusion

• While applying this model to the real world, an investor must ensure that the models are economically sound as well as transparent at the same time.

• But in practice, very few DCF models pass these tests.

• But now that you have gained some insights into “Mistakes in Discounted Cash Flow”, we hope that your model will stand apart.

Knowledge is like a line With no ends…

So To know in detail about this

article click on the link below

http://www.dcf-discounted-cash-flow.com/mistakes-in-

discounted-cash-flow/

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