When a company’s financials are scrutinized, metrics used to
evaluate the same are important. According to Wall Street, a company’s cash
flow is the best indicator for a company’s performance. As such, DCF or
discounted cash flow analysis is used to determine a company’s worth by
estimating future cash flows.
Projected cash flows (operating profit + depreciation + amortization
of goodwill - capital expenses - cash taxes - alteration in working capital) are
discounted to current value using company’s weighted average costs. In short,
DCF is an effective and unparalleled tool for determining share value, which is
important for investors.
Also, a few financial scandals only hiked the importance of
DCF. With more concerns about reliability of earnings and calculation of P/E or
cash flow determination, coming up with a DCF model calls for more efforts than
merely dividing share price by income or sales. However, taking this effort
ensures investors get a good idea of the key factors like share value, projection
of future income or profits, growth ratio, etc. Besides, DCF can’t be
manipulated through aggressive accounting practices easily.
While DCF is a very useful tool, it isn’t without
shortcomings. It is a mechanical valuation tool that works akin to garbage in,
garbage out saying. So, any minor change or change in assumptions could lead to
major differences. But, investors should always crosscheck evaluations and
allow considerable margin for such changes or errors, when taking decisions.
Major investment decisions should not be taken purely relying on DCF
calculations alone. What if a client backs off from a contract, or what if
interest rates hike unexpectedly or even a competitor cropping up with crushing
prices and the firm losing most business? Remember, when expectations change,
calculations or derivations based on the assumptions will change along with it!
Do you know even reputed investor Warren Buffet and other financial experts and
portfolio managers rely on DCF?
Discounting cash flow is tricky and it is important to
remember that assuming or predicting future estimates could be meaningful or
meaningless depending on the estimates taken and how reasonable they are.
Besides, numbers aren’t static and keep changing with changing trends. As for
investors, evaluating stock pricing is very important and DCF is a handy aid
for calculating the same, says Matthew
Roddan of Project Ninety Nine.
Do you know stock market speculations are based on DCF? Whether it is acquiring
a business, or a property, or investing on stock, DCF helps with speculating
approximately.
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