Top 3 Pitfalls of Discounted Cash Flow Analysis

Most finance courses espouse the gospel of discounted cash flow (DCF) analysis as the preferred valuation methodology for all cash flow-generating assets. In theory (and in college final examinations), this technique works great. In practice, however, DCF can be difficult to apply in evaluating equities.

Even if one believes the gospel of DCF, other approaches are useful to help generate a complete valuation picture of a stock.

Basics of DCF Analysis

DCF analysis seeks to establish, through projections of a company's future earnings, the company's real current value. DCF theory holds that the value of all cash flow–generating assets—from fixed-income bonds to stocks to an entire company—is the present value of the expected cash flow stream given some appropriate discount rate.

Basically, DCF is a calculation of a company's current and future available cash, designated as free cash flow, determined as operating profit, depreciation, and amortization, minus capital and operational expenses and taxes. These year-by-year projected amounts are then discounted using the company's weighted average cost of capital to finally obtain a current value estimate of the company's future growth.

The formula for this is usually given something like this:

$\begin{aligned} &PV = \frac{CF_1}{(1+k)^1} + \frac{CF_2}{(1+k)^2} + \cdots + \frac{CF_n}{(k-g)(1+k)^{n-1}}\\ \\ &\textbf{where:}\\ &PV = \text{present value}\\ &CF_i = \text{cash flow in the } i^{th} \text{ period}\\ &CF_n = \text{cash flow in the terminal period}\\ &k = \text{discount rate}\\ &g = \text{assumed growth rate in perpetuity beyond the terminal period}\\ &n = \text{the number of periods in the valuation model}\\ \end{aligned}$​PV=(1+k)1CF1​​+(1+k)2CF2​​+⋯+(k−g)(1+k)n−1CFn​​where:PV=present valueCFi​=cash flow in the ith periodCFn​=cash flow in the terminal periodk=discount rateg=assumed growth rate in perpetuity beyond the terminal periodn=the number of periods in the valuation model​

For equity valuation, analysts most often use some form of free cash flow for the valuation model cash flows. Free cash flows (FCF) is usually calculated as operating cash flow less capital expenditures (CapEx).

Note that the PV has to be divided by the current number of shares outstanding to arrive at a per share valuation. Sometimes analysts will use an adjusted unlevered free cash flow to calculate a present value of cash flows to all firm stakeholders. They will then subtract the current value of claims senior to equity to calculate the equity DCF value and arrive at an equity value.

The rule of thumb for investors is that a stock is considered to have good potential if the DCF analysis value is higher than the current value, or price, of the shares.

Problems With DCF

DCF models are powerful, but they do have shortcomings. Moreover, they often work better for some sectors than others. Here, we took a look at some of the possible pitfalls.

Operating Cash Flow Projections

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 outer 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. To make matters worse, cash flow projections in any given year will most likely be based largely on results for the preceding years. Small, erroneous assumptions in the first couple of years of a model can amplify variances in operating cash flow projections in the later years of the model.

Capital Expenditure Projections

Free cash flow projection involves projecting capital expenditures for each model year. Again, the degree of uncertainty increases with each additional year in the model. Capital expenditures can be largely discretionary; in a down year, a company's management may rein in capital-expenditure plans (the inverse may also be true). Capital expenditure assumptions are thus usually quite risky.

While there are a number of techniques to calculate capital expenditures, such as using fixed asset turnover ratios or even a percentage of revenues method, small changes in model assumptions can widely affect the result of the DCF calculation.

Discount Rate and Growth Rate

Perhaps the most contentious assumptions in a DCF model are the discount rate and growth rate assumptions. There are many ways to approach the discount rate in an equity DCF model. Analysts might use the Markowitzian R = R_f + β(R_m - R_f) or maybe the weighted average cost of capital of the firm as the discount rate in the DCF model.

Both approaches are quite theoretical and may not work well in real-world investing applications. Other investors may choose to use an arbitrary standard hurdle rate to evaluate all equity investments. In this way, all investments are evaluated against each other on the same footing. When choosing a method to estimate the discount rate, there are typically no surefire (or easy) answers. 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.

Many analysts 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 is therefore common to see a long-term growth rate assumption of around 4%, based on the long-term track record of economic growth in the United States. In addition, a company's growth rate will change, sometimes dramatically, from year to year or even decade to decade. Seldom does a growth rate gravitate to a mature company growth rate and then sit there forever.

Due to the nature of DCF calculation, the method is extremely sensitive to small changes in the discount rate and the growth rate assumption. For example, assume that an analyst projects company X's free cash flow as follows:

In this case, given standard DCF methodology, a 12% discount rate and a 4% terminal growth rate generates a per-share valuation of $12.73. Changing only the discount rate to 10% and leaving all other variables the same, the value is $16.21. That's a 27% change based on a 200 basis point change in the discount rate.

Alternative Methodologies

Even if one believes that DCF is the be-all and end-all in assessing the value of an equity investment, it is very useful to supplement the approach with multiples-based target price approaches. If you are going to project income and cash flows, it is easy to use the supplementary approaches. It is important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on the company's history and its sector. Choosing a target multiple range is where it gets tricky.

While this is analogous to arbitrary discount rate selection, using a trailing earnings number two years out and an appropriate P/E multiple to calculate a target price will entail far fewer assumptions to "value" the stock than under the DCF scenario. This improves the reliability of the conclusion relative to the DCF approach. Because we know what a company's P/E or price/cash flow multiple is after every trade, we have a lot of historical data from which to assess the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical and we do not really have any historical data to draw from when calculating it.

The Bottom Line

DCF analysis has increased in popularity as more analysts focus on corporate cash flow as a key determinant in whether a company is able to do things to enhance share value. It is one of the few equity valuation tools that can provide a real, intrinsic value against which to compare current stock price as opposed to a relative value comparing one stock to other stocks in the same sector or to the market's overall performance. Market analysts observe that it is hard to fake cash flow.

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 can be difficult to apply in real-world scenarios. Its potential weaknesses come from the fact that there are numerous variations analysts can select for the values of free cash flow and the discount rate for capital. With even slightly different inputs, widely varying value figures can result.

Thus, DCF analysis is perhaps best considered over a range of values arrived at by different analysts using varying inputs. Also, since the very focus of DCF analysis is long-term growth, it is not an appropriate tool for evaluating short-term profit potential.

Besides, as an investor, it's wise to avoid being too reliant on one method over another when assessing the value of stocks. Supplementing the DCF approach with multiple-based target price approaches is useful in developing a full understanding of the value of a stock.