Discounted Cash Flow or DCF
A key method in learning to valuate businesses and how to invest, and the investment process is learning to valuate businesses as if you were purchasing them.
One method of doing so is a Discounted Cash Flow or DCF analysis.
This method is applied via estimates to growth and using future free cash flow projections and discounts them and weights it versues the average cost of capital to arrive at a present value, which is used to evaluate the potential for investment.
The risk of a discounted cash flow analysis like any other model is that it is garbage in, garbage out and then you can make the formula say what you want to if you apply aggressive definitions. This is also a weakness of common analyst projections and models since they often use very aggressive assumptions.
Discounted Cash Flow is commonly known as DCF or D.C.F.
“Warren talks about these discounted cash flows. I’ve never seen him do one.” ”It’s true,” replied Buffett. “If the value of a company doesn’t just scream out at you, it’s too close.” – Charlie Munger, partner of Warren Buffett
Advantages of a Discounted Cash Flow Analysis
It requires an investor to think about the stock as a business and think of its cash flow rather then its earnings which can be deceiving.
Disadvantages of a Discounted Cash Flow Analysis
It is not suitable for start ups, growth companies, or businesses that are capital intensive where the cash flow is very difficult to ascertain. One must also use a suitable margin of safety.
Much debate about what the Weighted Average Cost of Capital is
Like all formulas it suffers from the garbage in, garbage out and one of the most debated components is what the Weighted Average Cost of Capital should be. We refer you to Warren Buffett’s thoughts.
“Our cost of capital is the production of our second-best ideas. I have listened to so many nonsensical cost-of-capital discussions. I have heard CFOs talk about it, but nobody knows what it is. The real test is whether the capital that we retain generates more in market value than is retained.”