Date post: | 24-May-2015 |
Category: |
Education |
Upload: | corporate-bridge-academy |
View: | 297 times |
Download: | 7 times |
WORLD EXCLUSIVES Finance News and Articles
Mistakes in Discounted Cash Flow
eduCBA presents…..
Aren’t we hearing about stocks and companies
on television and in newspapers every day?
And what was the daily news that you read?
Yes, it was always about various companies and
how their stocks went high or low.
Want to know how?? Continue reading……
Warren Buffet did not spend
his entire life being scared and
sitting in one corner of Wall
Street. Everyone knows where
he is now!!!
Scared of investing in shares already?
No, you don’t have to.
So now let’s get started on this topic …..
By now you must have a little idea of how financial ratios and multiples are used to analyze a company.
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.
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!!!
Analysts in big
investment banks
use DCF to
determine
company's current
value according to
its estimated
future cash flows.
But now we come to the main point….
The stock and
the company
that you
invested is at
its all-time low.
You lost your
money.
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!!!
1. Inappropriate Forecast
Horizon!!!
• A time frame of atleast five years needs to be considered while performing DCF analysis.
• But this does not mean that you consider the time frame of 50 years.
• Consider a proper explicit period that is not too short or not too long.
2. Cost of Capital!!!
• 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 Next Factor Is BETA…..
Beta reflects the sensitivity of a stock’s price movement
relative to the broader 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.
Beta’s empirical failure shows how beta does a poor job
explaining returns.
3. Mismatch between assumed investment and earnings growth…!!!
ROI helps in
determining the
efficiency with
which a
company
translates its
investments
into earnings
growth.
DCF models can
sometimes
underestimate
the investment
necessary to
achieve an
assumed
growth rate.
4. Incorrect consideration of other liabilities.
• 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.
• 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 the Risk
• 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 error.
7. Aggressive terminal growth rate assumptions.
• Generally the long term growth rate assumptions are taken wrong.
• Long-term rate of growth should not exceed the sum of inflation and real GDP growth at the most.
Some other types of Mistakes are…..
• Incorrect matching of real and nominal cash flows and discount rates.
• Failure to recognize "Typical" market conditions
• Errors in predicting the Tax rate.
Conclusion
• While applying this model to the real world, an investor must ensure that the models are economically sound as well as transparent at the same time.
• But in practice, very few DCF models pass these tests.
• But now that you have gained some insights into “Mistakes in Discounted Cash Flow”, we hope that your model will stand apart.
Knowledge is like a line With no ends…
So To know in detail about this
article click on the link below
http://www.dcf-discounted-cash-flow.com/mistakes-in-
discounted-cash-flow/
https://www.facebook.com/CorporateBridgeGroup
Be a part of edu CBA Family!!!
Visit our website
For Free Resources
Like us on Facebook
Follow us on Twitter
https://www.educorporatebridge.com/
https://www.educorporatebridge.com/free-courses/
https://twitter.com/corporatebridge
Thank
You!!!
If you have found this Presentation
to be useful, kindly
Like
Share
Follow us!!! +