Aren’t we hearing about stocks and companies on television and in newspapers every day? And during your finance courses weren’t you told to read newspapers daily? And what was the daily news that you read? Yes, it was always about various companies and how their stocks went high or low. You read about company related news that led the stock prices to move up and down. Scared of investing in shares already? No, you don’t have to. Warren Buffet did not spend his entire life being scared and sitting in one corner of Wall Street. Everyone knows where he is now!!!
So now let’s get started on this topic …..
By now you must have a little idea of how financial ratios and multiples provide a quick and easy way for investors to determine the general value of a stock and compare them in between companies. 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. DCF models help in estimating what the entire company is worth of. Comparing the intrinsic value of the stock (which is derived from the DCF valuation approach) with the stock’s current market price allows apples to apples comparison. 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!!!
DCF analysis is a key valuation method at an analyst’s disposal. Analysts in many big investment banks use this method of valuation for the company. They use DCF to determine company’s current value according to its estimated future cash flows.
But now we come to the main point…
What if you do not perform the DCF analysis in the right way? Yes, you are in a problem then. What is there are Mistakes in Discounted Cash Flow? What if your assumptions are not right and you come at an altogether different intrinsic stock price and you buy that stock. Yes you can be doomed.
After few months you are sipping your tea, reading your favorite financial newspaper and you see something that you never even dreamt of in your wildest dreams. Yes, the stock and the company that you invested is at its all-time low. You lost your money. Now you wish that you had done some proper analysis and assumptions. 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!!! The common mistakes are as follow
1. Inappropriate Forecast Horizon!!!
Consider that you are valuing a FMCG based company, but you consider the projections for only two years. Do you think that it is a right approach? Definitely not!!! A time frame of atleast five years needs to be considered which performing DCF analysis. But this does not mean that you consider the time frame of 50 years, that would be absolutely wrong. Imagine the interest rates, economic factors, inflation after 5o years, and we do not have some kind of financial super power to predict the same. John Maynard Keynes rightly said,
“I’d rather be vaguely right than precisely wrong”.
His message applies here. Consider a proper explicit period that is not too short or not too long.
2. Cost of Capital
Many DCF model are built on non-sensible cost of capital. this is one of the major mistakes in Discounted Cash Flow. Here are the reasons why. Most companies largely use either debt or equity for financing their operations. 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 cost of equity is usually higher than the cost of debt because equity’s claim is junior. And no simple method exists to estimate the most accurate cost of equity.
By far the most common and used approach for estimating the cost of equity is the capital asset pricing model (CAPM). According to CAPM, company’s cost of equity is equal to the risk-free rate plus the product of the equity risk premium and beta. Government-issued bonds generally provide a good representation for the risk-free rate. But estimating the equity risk premium and beta proves to be much more challenging.
Let’s start with beta for now. Beta reflects the sensitivity of a stock’s price movement relative to the broader market. A beta of 1 suggests that the stock tends to move in line with the 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. Ideally, we want forward-looking betas, which is difficult to reliably estimate. Beta’s empirical failure shows how beta does a poor job explaining returns.
The second important input into the CAPM which can cause errors is the equity risk premium. As like the Beta, equity risk premium is a forward looking estimate. Relying on past equity risk premium values, may not give a reasonable sense of the return outlook. In addition to this, research also suggests that the equity risk premium is possibly non-stationary, thus using past average values can be very misleading.
3. Mismatch between assumed investment and earnings growth.
You must be aware of how Companies invest in the business via working capital, capital expenditure, acquisitions, R&D, etc. All this steps are taken in order to grow over an extended period. Also by now you can easily understand how “Return on investment” (ROI) helps in determining the efficiency with which a company translates its investments into earnings growth. Since ROI is linked to investment and growth, investors must treat the relationship between investment and growth carefully. DCF models can sometimes underestimate the investment necessary to achieve an assumed growth rate. The source of this mistake is as follows. First, analysts looking at companies that have been highly acquisitive in the past consider the same growth rate now, even if the company is not that much into acquisitions as it was before. One can overcome this mistake by carefully considering the growth rate that is likely to come from its today’s business.
4. Incorrect consideration of other liabilities.
One of another mistakes in Discounted Cash Flow is with respect to other liabilities. The Corporate Value is determined based on the present value of future cash flows. Cash and any other non-operating assets are added while debt and any other liabilities are subtracted to arrive at shareholder value.
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. At the same time such other liabilities are most common in some sectors. For example, other post retirement employee benefit plans are more common in manufacturing industries while employee stock options occur most frequently service industries. 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
Always make sure that your model does not get into the mistakes of double counting. Now you must be wondering that what exactly is double counting. So lets understand it in simple terms. Double counting simply means that some values are taken twice thus causing errors in the model. Considering the values twice can also bring about changes in your intrinsic share price. Double counting can also take place in considering the risk factor.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 double counting of the risk and thus lead to error.
7. Aggressive terminal growth rate assumptions
Think of it in this way. Just for one day consider that you are some insurance agent. You are able to get many customers, you have over achieved your target. But how? You told your clients that they will get sure shot 30 % returns and this figure will increase cumulatively in the coming years. By this way you were able to fool the clients but can you fool yourself? You cannot guarantee your clients with some dreamy figures of growth. Things do not work like that. You have to take into account all the possible factors that affect the growth rate and then promise your clients. Same is the case when you build your DCF model. Generally the long term growth rate assumptions are taken wrong. These assumptions are taken to determine the terminal value component of the DCF valuation. You have to bear in mind that the long-term rate of growth should not exceed the sum of inflation and real GDP growth at the most. Terminal value contributes around 70-80% of the fair valuation and hence, we should be cautious while making assumptions of terminal growth rate.
Generally, if a 1% higher terminal growth is assumed than the normal, then the share price valuation may jump by as much as 15-25%!
8. Incorrect matching of real and nominal cash flows and discount rates.
Let’s understand the difference between real and nominal here. Cash flows that incorporate the effects of inflation are on a nominal basis, whereas cash flows that exclude its effects are on a real basis. Thus where real cash flows are used, the impact of inflation needs to be considered into the discount rate. Often errors are seen here as no adjustments are made.
9. Failure to recognize “Typical” market conditions
Sometimes it can happen that, income and operating statements for a particular project do not reflect normal operating patterns. Thus ultimately this will have the effect on your DCF model and the intrinsic share price. In such a case it is necessary to reconstruct the actual operating statements to reflect market conditions. Thus to properly measure market value, the projected operating or income statements must attempt to reflect actual market conditions.
10. Errors in predicting the Tax rate.
The general mistake here is adopting a tax rate which does not reflect the long term tax rate for the asset. In order to properly reflect expected future cash flows, forecasts should be based on the expected effective tax rate applicable to the asset at that time. Hence while projections you may like to devote some time into properly analyzing the corporate tax rate also. It may sound like a small term but properly analyzing the tax rate and then considering it in your model will surely bring your model one step closer to perfection.
The final word….
So now that you have learnt about all the probable things that can go wrong in DCF calculations, you should be well prepared while performing your own model. While applying this model to the real world, you as an investor or a student must ensure that the models are economically sound as well as transparent at the same time. But in practice sometimes it may happen that, very few DCF models pass the tests. But now that you have gained some insights into “Mistakes in Discounted Cash Flow”, we hope that your model will stand apart. This article on Mistakes in Discounted Cash Flow can act as a safety check to avoid paying too much for any stock. If you further wish to hone your DCF skills you may like to visit – Everything you need to know about DCF
All the very best.
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