DCF valuation – The Pro & Cons

DCF analysis is widely used in the investment communities. In fact, it is one of the most commonly used valuation method that you may see in analyst reports.

As an investor, DCF valuation can be a handy tool that serves as a way to confirm the fair value prices published by analysts. It requires you to consider many factors that affect a company, including cash flow growth and capex. You’ll also have to think about the discount rate, which is influenced by the risk-free rate of interest.

But, DCF is not the holy grail – It’s not even close.

It’s important to consider the method’s strengths and weaknesses.

Pro

• DCF offers the closest estimate of a stock’s intrinsic value. It’s considered the most sound valuation method if the analyst is confident in his or her assumptions.
• Unlike other valuation methods, DCF relies on free cash flows, considered to be a reliable measure that eliminates subjective accounting policies.
• DCF isn’t significantly influenced by short-term market conditions or non-economic factors.
• DCF is particularly useful when there’s a high degree of confidence regarding future cash flows.

Cons

• DCF valuation is very sensitive to the assumptions/forecasts made by the analyst. Even small adjustments can cause DCF valuation to vary widely – which means the fair value may not be accurate.
• DCF tends to be more time-intensive compared with other valuation techniques.
• DCF involves forecasting future performance, which can be very difficult, especially if the company isn’t operating with 100% transparency.
• DCF valuation is a moving target: If any company expectations change, the fair value will change accordingly.

We will dwell into its cons. Take note on the few keywords – SENSITIVE, involves FORECASTING and CHANGE.

This means DCF valuation is powerful, but they are only as good as their inputs. As the axiom goes, “garbage in, garbage out”. Small changes in inputs can result in large changes in the estimated value of a company, and every assumption has the potential to erode the estimate’s accuracy.

How do we overcome this?

First, you need to think about why you are valuing stocks in the first place.

Valuation exists purely so that you know how much that you should pay for an asset. Our goal isn’t to have a 100% accuracy rate. That would be awesome, but impossible.

We want to be approximately right and profit by having a good range of intrinsic values and then apply discipline and margin of safety rules.

In TRV Stock Analyzer, we have automated sensitivity matrix for DCF valuation.

A sensitivity analysis is a technique used to determine how different values of an independent variable impact a particular dependent variable under a given set of assumptions.

From the Part 1 of the DCF valuation, we have calculated the fair value for RGB by using DCF. RGB fair value is at 0.361.

But, what if the stock growth 4% point higher? Or what if the discount rate that we use is too low?

The sensitivity matrix will be able to give you the answer for the question above.

The sensitivity matrix is calculated based on change in growth rate and discount rate while other parameter remains constant. It will help to answer this question – What if the company growth 4% point higher?

From the matrix, we can see 25 valuations and 25 calculations for margin of safety. There is a valuation for each growth rate and discount rate.

From the picture above, we can see the valuation for RGB is 0.361 if the discount rate is at 10% and growth rate is at 8.3% (Highlighted in RED boxes).

What if RGB growth 4% point higher?

You can directly see the valuation for RGB if the growth rate is at 12.3% (Highlighted in BLUE). The valuation is 0.456 with 10% discount rate.

What if we use a discount rate of 11%?

You can move to the column of discount rate 11% (furthest right). The valuation for discount rate 11% with 8.3% growth is 0.325 (Highlighted in PURPLE).

There are a total of 25 scenarios is generated based on each growth rate and discount rate.

The matrix is also colour coded based on its margin of safety. At a glance we can know if the stock is undervalued based on its colour.

Example of UNDERVALUED stock matrix

Example of FAIRLY VALUED stock matrix

Example of OVERVALUED stock matrix