Most stock analysts want to be able to predict the future. As a result, projecting or forecasting financial statements, especially the income statement, is a commonly used tool. Another commonly used tool is discounted cash flow. DCF is a business valuation methodology which uses projected financial statements in order to determine the value of a company's stock.
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The Advantage of Future Values
DCF is a financial measure which uses the time value of money in order to determine security pricing. TVM is a financial principle which states that a dollar today is worth more than a dollar tomorrow if invested at a rate which is greater than inflation. Much of finance is centred around this principle especially with regard to finding the present value of future cash flows. DCF is one of the few valuation methods which looks at a company's future cash flow potential instead of historical cash flows to determine security value. The challenge is determining the cash flows.
The Disadvantage of Cash Flow Projections
Cash flows are projected and forecasted over a period of at least five years. There is a saying in the world of finance: "Garbage in; garbage out." That is, the data you put into a financial model must be reliable in order for the data output to be useful. In other words, the DCF model is only as good as the analyst building it. This is the primary disadvantage of the DCF method.
The Disadvantag of Forecasting Inputs
The general rule for forecasting cash flows is to start with net income, add back depreciation expense and subtract capital expenditures. All of these variables must be forecasted in order to arrive at a working DCF model. The present value of each year of cash flows is then determined by dividing cash flows by prevailing interest rates. This is another disadvantage with the model since it very difficult to forecast interest rates. The sum of these present values is the present value of the company.
The Advantage of Scenarios
In addition to net income and interest rates, there are many other assumptions that need to be considered when computing the DCF. As a result, analyst like to provide a range of values under different assumptions. The dynamism of the model allows analysts to quickly change inputs to see the effect of outputs. These changes are referred to as model scenarios.
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