Discounted Cash Flow Method – 7 Reasons Why It Does Not Work

Crystal Gazing

15 Jun Discounted Cash Flow Method – 7 Reasons Why It Does Not Work

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?

We know that trying to pick stocks can be very frustrating. Skip that frustration, get 21 ideas to finding profitable stocks in an instant. 

#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.

Practise Conservatism

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.



---------

Grant Yourself The Ability To Make 10 - 15 % Returns Annually. Lifetime Access. Learn at your convenience. Bag stock market profits with ease: Access Now!


New to investing and could use some free and useful guides? Check out: "How to start investing in Singapore"

3 Comments
  • Troy
    Posted at 00:31h, 27 June Reply

    I actually use DCF occasionally. In defence of DCF, I must say that while past performance does not guarantee future performance, it does give a guide. A trend. If we use DCF only on consistent performers who have shown consistent revenue and profit growth, consistent levels of debt and capex, we have some assurance that that consistency will continue.

    It is not a magic formula, and is not meant to be, but a useful valuation method. Although P/E is probably easier, DCF measures cashflow which I think is more important.

    For companies with volatile figures, throw out DCF.

    For asset-based companies, I use NAV.

    • Alvin
      Posted at 06:30h, 27 June Reply

      Agreed if it is used as a guide for companies with steady earnings due to their competitive advantages.

  • Loong
    Posted at 19:47h, 07 August Reply

    Alice Schroeder on How Buffett Values a Business and Invests
    http://www.youtube.com/watch?v=PnTm2F6kiRQ

    On November 20, 2008, Alice Schrooder, author of “The Snowball: Warren Buffett and the Business of Life”, spoke at the Value Investing Conference at the Darden School of Business. She gave some fascinating insights into how Buffett invests that are not in the book. I hope you find them useful.
    Much of Buffett’s success has come from training himself to practice good habits. His first and most important habit is to work hard. He dug up SEC documents long before they were online. He went to the state insurance commission to dig up facts. He was visiting companies long before he was known and persisting in the face of rejection.
    He was always thinking what more he could do to get an edge on the other guy.
    Schroeder rejects those who argue that working harder will not give you an edge today because so much is available online.
    Buffett is a “learning machine”. This learning has been cumulative over his entire life covering thousands of businesses and many different industries. This storehouse of knowledge allows Buffett to make decisions quickly.
    Schroeder uses a case study on Mid-Continent Tab Card Company in which Buffett invested privately to illustrate how Buffett invests.
    In the 1950′s, IBM was forced to divest itself of the computer tab card business as part of an anti-trust settlement with the Justice Department. The computer tab card business was IBM’s most profitable business with profit margins of 50%.
    Buffett was approached by some friends to invest in Mid-Continent Tab Card Company which was a start-up setup to compete in the tab card business. Buffett declined because of the real risk that the start-up could fail.
    This illustrates a fundamental principle of how Buffett invests: first focus on what you can loose and then, and only then, think about return. Once Buffett concluded he could lose money, he quit thinking and said “no”. This is his first filter.
    Schroder argues that most investors do just the opposite: they first focus on the upside and then give passing thought to risk.
    Later, after the start-up was successfully established and competing, Buffett was again approached to invest capital to grow the business. The company needed money to purchase additional machines to make the tab cards. The business now had 40% profit margins and was making enough that a new machine could pay for itself in a year.
    Schroeder points out that already in 1959, long before Buffett had established himself as an expert stock picker, people were coming to him with special deals, just like they do now with Goldman Sachs and GE. The reason is that having started so young in business he already had both capital and business knowledge/acumen.
    Unlike most investors, Buffett did not create a model of the business. In fact, based on going through pretty much all of Buffett’s files, Schroder never saw that Buffett had created a model of a business.
    Instead, Buffett thought like a horse handicapper. He isolated the one or two factors upon which the success of Mid American hinged. In this case, sales growth and cost advantage.
    He then laid out the quarterly data for these factors for all of Mid Continent’s factories and those of its competitors, as best he could determine it, on sheets of a legal pad and intently studied the data.
    He established his hurdle of a 15% return and asked himself if he could get it based on the company’s 36% profit margins and 70% growth. It was a simple yes or no decision and he determined that he could get the 15% return so he invested.
    According to Schroder, 15% is what Buffett wants from day 1 on an investment and then for it to compound from there.
    This is how Buffett does a discounted cash flow. There are no discounted cash flow models. Buffett simply looks at detailed long-term historical data and determines, based on the price he has to pay, if he can get at least a 15% return. (This is why Charlie Munger has said he has never seen Buffett do a discounted cash flow model.)
    There was a big margin of safety in the numbers of Mid Continent.
    Buffett invested $60,000 of personal money or about 20% of his net worth. It was an easy decision for him. No projections – only historical data.
    He held the investment for 18 years and put another $1 million into the business over time. The investment earned 33% over the 18 years.
    It was a vivid example of a Phil Fisher investment at a Ben Graham price.
    Buffett is very risk averse and follows Firestone’s Law of forecasting: “Chicken Little only has to be right once.” This is why Berkshire Hathaway is not dealing with a lot of the problems other companies are dealing with because he avoids the risk of catastrophe.
    He is very realistic and never tries to talk himself out of a decision if he sees that it has cat risk.
    Buffett said he thought the market was attractive in the fall of 2008 because it was at 70%-80% of GDP. This gave him a margin of safety based on historical data. He is handicapping. He doesn’t care if it goes up or down in the short term. Buying at these levels stacks the odds in his favor over time.
    Buffett has never advocated the concept of dollar cost averaging because it involves buying the market at regular intervals – regardless of how overvalued the market may be. This is something Buffett would never support.

Post A Comment

Another popup!? 

We Are Sorry! But WAIT...

Since you are already reading, why not read on? You are probably reading an article on this site because you are interested in investing and personal finance.

 

If that's true, this value packed ebook, "Investing Your First $20,000" would definitely help you.

 

Simply enter your email below and we will send you the ebook plus insightful finance articles just like the one you were reading before this popup - right to your inbox. No more popups!

 

Try it. You can unsubscribe any time.

Good Job!

Thank You For Your Time

Do check your email for the ebook!