The Dubious Value of Discounted Cash Flow Analysis
The Dubious Value of Discounted Cash Flow Analysis
Novice investors often make the mistake of purchasing stock in a company because they believe it is well run or they see lots of customers buying that company's products or services. For instance, many people remark to me that Apple seems like a good investment because their stores always seem to be packed with customers and their products, be it the iPhone, the iPod, or the iPad, seem to be everywhere.
The problem is that such investors fail to differentiate between good companies and good stocks. A well-run company may have a stock that is overvalued because its price is higher than its present and foreseeable business operations justify. Is Apple worth $360 per share, or is its value much more or less than that? How can an investor determine this?
Many financial analysts rely on a method known as discounted cash flow analysis to answer this question. This method typically involves forecasting a company's future financial statements, often over a five year period, in order to project a company's future cash flows. These cash flows are then discounted using the company's weighted-average cost of capital (i.e., the proportional cost that the company incurs to obtain debt and equity financing). This takes into account that possessing a dollar today is worth more than receiving a dollar several years from now. A dollar received now is worth more because you can earn interest on it, or reinvest it at a potentially higher rate of return.
Whether an analyst can accurately project a company's financial statements and free cash flow five years into the future is subject to debate. Growth rates revenue, cash flows, expenses, and other items are not constant and are influenced by factors such as the business cycle stage, industry structure, and corporate strategy. These influences can be forecasted as well, but I find that economic and stock market forecasts are anything but definitive. Noted economists and financial pundits are often wrong and the ones that forecast the most dramatic scenarios receive the most media attention.
Despite these reservations, my experience has been that five year free cash flow projections are typically quite accurate. They may not anticipate extraordinary events, such as an uprising in Libya or an oil spill in the Gulf of Mexico, but no one ever suggested that financial analysts hold a crystal ball. When such incidents occur, free cash flow forecasts can be revised to incorporate new, material information.
My larger concern relates to how one addresses free cash flow beyond the five year forecast period. Usually, financial analysts employing discounted cash flow analysis of this nature incorporate a terminal period or a series of them into their model. In order to forecast free cash flow for a terminal period, it is necessary to multiply projected free cash flow in the final year of annual forecasting by the expected perpetual growth rate and then divide that by the company's weighted-average cost of capital less the projected perpetual growth rate using the following formula:
FCF x (1 + g)
WACC -g
Herein lies a key problem: what is a company's growth rate into the infinite future? From now until forever, what will Apple's growth rate be? 3%, 5%, or some other number? Will Apple exist in 20 years, 50 years, or 100 years? In the context of predicting major events, I stated that financial analysts do not have a crystal ball. So why do they think that they are able to forecast a perpetual growth rate with any accuracy?
More alarming is the importance of this projection in determining the appropriate price for a company's stock. While many analysts suggest that the accuracy of cash flow projects into infinity are not important because their present value falls exponentially over time due to discounting, the terminal value often still represents over 50% of a corporation's calculated stock price, and sometimes much more. More importantly, a slight change in the terminal growth rate often has a dramatic impact on forecasted stock price. This leaves an analyst more susceptible to potential biases. For example, if the current stock price of Apple is $360, an analyst is probably less likely to submit a discounted cash flow model to his or her manager that shows a price projection of $600 per share value for the stock than a $400 value even though this was his or her initial calculation. The easiest method for adjusting this result is to adjust the terminal growth rate. What manager is going to quibble over a half percent change in this figure given the difficulty of projecting infinite cash flows? However, who is to say that the original projection is not more accurate simply because there is a large difference between the current and forecasted price of the stock?
In October 2008, in the midst of a recession, I prepared a detailed financial and competitive analysis of Boeing Corporation with Steven Maxfield, who is now an analyst with Intel Corporation. At the time, Boeing was trading around $40 and our analysis suggested that the appropriate price for the company's stock was $95. This seemed like a very high price estimate at the time.
Two and a half years later, Boeing's stock price has increased by about 80%, but is still below our projected price. While we employed discounted cash flow analysis as part of our report, I believe the key to determining that the stock was undervalued was due to our qualitative analysis that Boeing was in a good competitive position rather than our quantitative analysis. The important lesson to learn is that there are limitations to discounted cash flow analysis and that it is only one tool in determining the appropriate value of a stock.
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