Critical Look at using DCF for Valuations

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Professor Damodaran has written a ton of articles about Discounted Cash Flow (DCF) analysis over the years.  I don’t think another website has as much information about valuation and DCF as on his blog – so it is a wonderful resource to visit and use for investors.  His latest blog post on DCF which defends the use of DCF as a valuation technique is a good topic.  Many investors have discredited the use of the DCF technique and Damodaran tries to initially cover some of these myths and focus on the critical use of DCF in valuing companies.  It appears that he will cover, in detail, the myths of DCF over the upcoming year!

It is my opinion that a DCF analysis, in theory, is the right way to value a business or asset.  An asset is only valuable if it will give a return to an investor.  An asset has a defined life, and the total amount of cash returned to an investor over the life of an asset, discounted for risk and time value of money is the final value of that asset.  The theory is solid, as is the basic DCF calculation process.  This simple chart is a great overview of the DCF process:

DCF Calculation

Provided by Professor Damodaran:

I took my fair share of finance classes while obtaining my MBA, and one gets plenty of practice using DCF along with many academic sessions discussing the model’s pro’s and con’s.  The value investing community sometimes has a negative slant on the academic side of finance and investing.  This comes from the fact that finance classes tend to teach the Efficient Market Theory (EMT), and value investors overwhelmingly disagree with the EMT.  Somehow, the DCF model gets swept up in this argument, and the model gets negated.  In the basic sense, the DCF model is based upon sound principles – the future return (cash flows) of an asset, over its life, discounted back to today’s value is exactly how an investor should value assets (and businesses).  The big criticism, from my point of view, is that it is very hard to estimate the future accurately enough to use as a value to judge whether a security should be purchased or sold.  Damodaran seems to disagree with this philosophy to an extent saying that the DCF can be used for all types of assets in all stages of growth – but I don’t think the strong arguments are coming from this angle.

Criticism of DCF Models:

  • Too Complex of a model
  • Terminal Value is a large percentage of final value
  • Cost of Capital is hard to determine
  • Discount Rate is hard to determine
  • Impossible to accurately determine Cash Flows in Future

The above are some common criticisms of the DCF model, and I don’t think that many of them hold water, except for the last item, which is a huge problem.  The model is does not need to be complex, and the discount rate can be set to something near accurate enough with the amount of information available on the Internet today.  The terminal value can be tricky, especially if performing just a 5 year DCF model on a long-lived asset because the terminal rate may not accurately depict the future cash flows of the asset.  This can be rectified by elongating the number of years in the DCF.  However, one will end up running into the largest problem, how to accurately input cash flows that far into the future?  This is a big complain of Greenwald, and one of the reasons he favors his Earnings Power Value (EPV), as it does not take into account any future growth, and values an asset off of its normalized earnings.

Of course, no one should be fooled into thinking that an investor/analyst can calculate a value of a security or asset to an exact value.  That’s why value investors must insist upon a margin of safety, knowing that the inputs into the valuation model have a certain error rate, and the best that can be hoped for is to come within a range of values for the value of a company.  What that margin equates to should depend on the nature of the business – a less volatile business with fairly steady earnings and cash flows could potentially need a lower margin of safety than a start-up business.  The idea is that the likelihood of accurately predicting the start up’s cash flows is much less than a steady state business.

In the end, I think everyone will still sit on one side or the other and not be swayed around the value of the DCF model.  I don’t think anyone can argue that the idea of the model, and the principles behind it are solid, the most criticism comes from the idea of not knowing how to accurately predict growth rates, cash flows, discount rates etc…  Fluctuations in the input numbers can have drastic effects on the outcomes, and basically comes down to the old adage – Garbage In, Garbage Out.

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Today begins Professor Damodaran’s Valuation class – and he is very generous in offering all of his material on his website.  Follow along the valuation class yourself.


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