Open Sources: Learn About Discounted Cash Flow Models

Summary

• Discounted Cash Flow analysis is one of the primary valuation methods.
• Seeking Alpha authors should understand the strengths and weaknesses of a DCF model and best practices.
• Here we look at resources for learning about DCF analysis.

Open Sources is an Author Experience series that focuses on free investment-related tools from across the Web.

(Estimating the present value of a future stream of cash flows is essential to investing. Source: Corporate Finance Institute.)

By John Leonard

Discounted Cash Flow (DCF) analysis is one of the most widely used valuation methods - and for good reason. Some of its strengths are:

• Provides an absolute valuation - unlike with a relative valuation analysis, in which a stock may appear undervalued compared to peers but all of the peers could be overvalued or the peer group may not be accurate/meaningful.

• Uses FCF rather than GAAP earnings - the latter is less useful to determine the intrinsic value of a business.

• Allows investors to use their own assumptions as key inputs to create a more differentiated thesis.

• Allows investors to easily stress-test a thesis by changing key assumptions using a sensitivity analysis.

However, there are also several weaknesses:

• The upside of being able to use your own assumptions is that these could be wrong - if actual cash flow is materially different from projected cash flow, the model is less useful (putting it nicely).

• The “garbage in, garbage out” problem inherent in all models - if any (emphasis on any - not all) of the inputs are unreasonable, the output (in this case the price target) is less useful. MS Excel is only going to do what you tell it to. If you input a 20% terminal growth rate or a 1% WACC, it is not going to give you a sanity check (like a PM surely would).

• Small changes in assumptions have a large impact on output (slightly increasing the terminal growth rate or lowering WACC can completely change a thesis).

DCF Resources

As Mike Taylor mentioned in a previous edition of the Author Experience, NYU professor Aswath Damodaran provides a lot of useful (and free!) resources. You can check out the spreadsheets here by clicking on Tools on the top nav bar, then Valuation below Spreadsheets. For more references and tools, check out CFA Institute’s page on Equity Valuation Models here.

Here you can find a detailed walk-through of the discounted cash flow model from an MIT course. To get a highly detailed look at some pioneering work in financial valuation, check out Irving Fisher’s 1930 book, The Theory of Interest.

For an example of how a Seeking Alpha author uses DCF analysis, see this recent Top Idea by Grier Buchanan on Conduent (CNDT).

Using Software

This YouTube introduction to financial modeling by Wall Street Prep may also come in handy. The Wolfram Alpha page for discounted cash flow lets you toggle the inputs to get a better sense of the relationships between the variables.

Conclusion

A DCF model can provide additional valuation support, provide a better estimate of intrinsic value and allows an investor to express their own unique insights and assumptions. Just remember, as with any tool, it is only useful when used properly.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.