Discounted Cash Flow (DCF) method is one of the popular ways to calculate the intrinsic value of a stock. The argument is that financial ratios only tell us about how the company has performed in the past, and nothing about the future. Hence, it is better to project the company’s worth in the future to today’s value. I have problems with projections because I simply do not believe in it. No one can predict the future accurately and I have seen more incorrect predictions of GDP and inflation rates than correct ones. And these predictions are made by smart economists, not the average Joe like you and me. DCF’s main problem is the over-reliance on predictions.
I will not be going through DCF’s complex formulas in this post as I only want to address the weaknesses of the method. Investopedia has covered well about the method which you can read about it here. Otherwise, let’s begin.
#1 Predicting Revenue Growth
One of first thing you predict is revenue growth. The question is that even the CEO does not know how much would the company’s revenue grow in the next few years, lest to say an outsider trying to value the company. If you insist, it is more acceptable to predict revenue growth for companies with competitive advantage. You can be more certain a company can continue to grow and capture market share when there are no strong competitors. But there aren’t many companies with competitive advantage and hence, DCF cannot work for most of the companies out there.
#2 Predicting Operating Costs
The company needs to pay out salaries, rentals, raw materials, utilities etc. Are we able to predict how much would these costs change in the next 10 years? Are we even able to predict our utility bills or price of oil 6 months later? I am not confident and I do not know about you. If smart economists can get inflation rate projection wrong, what makes us think that we can predict the rise and fall of companies’ operating costs?
#3 Predicting Capital Expenditure
Let us assume we got it right about our prediction for #1 (revenue growth) and the company indeed made more money but now we have to predict another thing – what would the CEO do with the earnings in the next 10 years? You mean now we have to predict human behaviour? Gosh! How do we know how much would the CEO spend on expansion, buying machinery, etc, and when will he spend it?
#4 Predicting Change in Working Capital
Working capital is the difference between the current assets and current liabilities. “Current” in accounting means less than a year. In other words, the assets are liquid and can be converted/used within the year, and current debts are due within the year too. Since they are so liquid, the items can move in and out of the company easily and frequently. Tracking the movements of these assets and liabilities already takes up a lot of effort. Predicting the changes in current assets/liabilities for the next few years would be even more challenging.
#5 Predicting Risk-free Rate
Interest rate is pretty much controlled by the Fed (and somehow it has a lot of influence on the interest rates in the rest of the world). Although the Fed has been criticised for being lax on monetary policies for many years, it is hard to predict when they would change their mind and stop their money printing press. Yes, there have been speculation of halting QE3 but nothing is certain until it happens. Hence, how do you accurately predict the interest rate in the DCF method?
#6 Predicting Change in Beta
Beta is a term coined by the finance professors to confuse the average Joe. It is one of those numerous sexy terms that professionals use to make them look smart in front of their clients. In simple terms, Beta is a number, which is assigned to a stock based on the correlation of its price with the general market’s movement. It is to measure how volatile the stock price is. A Beta of higher than 1 means it is more volatile than the overall market. But correlation and Beta is not constant for a stock. If you can predict Beta accurately, why don’t you predict the stock price directly?
#7 Assumptions and more Assumptions
The DCF method hinges on the accuracy of assumptions. And we know that assumptions are often invalidated by reality. DCF users will have to constantly update their model regularly. But soon after they updated the assumptions, there are bound to be new developments to render their assumptions obsolete again. It will never end. Assumptions over and over again.
If you are to use DCF, my advice is to be conservative with your assumptions. But then again, if you are so pessimistic with the assumptions, you will probably not able to find anything worth investing. So what is the value of using DCF? I think we should shift all the books on DCF to the fiction section.
Remember: It is not about how good the method is. The success of your investment hinges on the accuracy of the assumptions you have used in the calculation of DCF, which in my opinion, there are too much room for errors when you have to predict so many things.