7 Reasons Why the Discounted Cash Flow Method Does Not Work for Retail Investors

June 24, 2014

in Investing

By Alvin Chow (guest contributor)

The Discounted Cash Flow (DCF) method is one of the most 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.

For a start, I have problems with projections because I simply do not believe in them — no one can predict the future accurately. Furthermore, I have seen more incorrect predictions of GDP and inflation rates than correct ones, and these had been predictions made by smart economists, not laypeople like you and me.

Essentially, DCF’s main problem is its over-reliance on predictions. I will skip DCF’s complex formulae and directly address the weaknesses of the method in this post:

#1 Predicting Revenue Growth

One of the first things you predict is revenue growth. The problem is that even the CEO does not have exact figures on it for the upcoming years, much less an outsider trying to value the company. If you insist, then I would say that it is more acceptable to predict revenue growth for companies with a competitive advantage, where you can be more certain of a company’s potential to grow and capture market share when there are no strong competitors. Considering that there are, however, not many companies with a solid competitive advantage, DCF cannot work for most of them out there.

#2 Predicting Operating Costs

The company needs to pay out salaries, rentals, raw materials, utilities and so on. Can we predict how much these costs would change in the next decade? Are we even able to predict our utility bills or the price of oil six months later? I do not know about you, but I am unconfident of my own guesses. If smart economists can get inflation rate projections wrong, what makes us think that we can predict the rise and fall of companies’ operating costs?

#3 Predicting Capital Expenditure

Assuming that we correctly predicted the company’s revenue growth as in #1 and that the company made more money, we have to burden ourselves with yet another prediction — what would the CEO do with the earnings in the next 10 years? Does this mean that we now have to predict human behavior? Gosh! How would we know just how much and when the CEO would spend on expansions, machinery and so on?

#4 Predicting Change in Working Capital

Working capital is the difference between 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. The former means that items can move in and out of the company easily and frequently. Tracking the movement of these assets and liabilities already takes up plenty of effort; predicting the changes in current assets/liabilities for the next few years would be even more challenging.

#5 Predicting the Risk-free Rate

Interest rate is pretty much controlled by the Federal Reserve (which somehow has a lot of influence on interest rates in the rest of the world). Although the Fed has been criticized for being lax on monetary policies for many years, it is hard to predict when they would change their minds and stop their money printing press. Yes, there have been speculations of halting QE3 but nothing is certain until it happens. As such, how do you accurately predict interest rates with the DCF method?

#6 Predicting Change in Beta

“Beta” is a term coined by finance professors to confuse laypeople. It is one of those numerous sexy lingo 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 measures how volatile the stock price is. A Beta of higher than 1 means that it is more volatile than the overall market. But correlation and Beta are 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 update their model constantly. But soon after each update, there are bound to be new developments that render their assumptions obsolete again. It will never end. Assumptions will have to be made over and over again.

Practice Conservatism

If you intend 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 be able to find anything worth investing in. So what is the value of using DCF? Some have their arguments, but my stand is that we should shift all the books on DCF to the fiction section.

Remember: it is not about how good the method is purported to be. The success of your investment hinges on the accuracy of the assumptions you have used in the calculation of DCF, which in my opinion, holds too much room for errors when you have to predict so many things.

By guest contributor Alvin Chow, who blogs at Big Fat Purse, a Singapore personal finance blog.

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