Just as we need to be cautious when using accounting information, here's a word of warning when you're using discounted cash flow analysis. And this is true for absolute valuation methods as much as it is true for the relative valuation methods, the multiples that we discussed earlier. Valuation models assume that markets are often inefficient. For some reason, they get it wrong. They don't get the right price for the cash flow entitlement. But, eventually these markets come to their senses, and the market value would equate to what we could label as, the true value. Well that's a big call. Keep in mind, that first and foremost, financial analysts have got conflicting interests. So, financial analysts' valuations are inevitably biased, either in the sign of their valuation, whether it's a positive or a negative net present value, or the size of the net present value forecast. Sign and size of the bias will depend on the type of analyst. And with that, we refer to sell-side analysts versus buy-side analysts. Those analysts that work for someone who is buying will want to put a lower value on the analysis, whereas those analysts that work for people that are selling will want to inflate the price. So be careful with analyst valuations. And also not unimportantly, keep in mind that the more complicated valuation models are not necessarily more accurate. Keep it simple is the simple guidance here. It's an art, not a science. So, let's just recap the discounted cash flow valuation principles. What does DCF really stand for? We know that firm or project value as we discussed it today is the present value of the firm or projects expected future cash flows. That fundamental principle of valuation assumes that the firm or the project has something which we could label as intrinsic or real value, based on its current cash flows, and the growth in those current cash flows, and risk of those current cash flows evolving in the future. What the analyst does is the following. The analyst for DCF needs to estimate the effective life of the project or the firm, choosing n, the expected cash flows and then properly timed over the effective life of the cash flow of the project or the firm. And lastly the analyst needs to find the right discount rate, get a good assessment on expected inflation, on the risks embedded in the project, and on the opportunity costs, debt seems to be a big ask. The inputs are all important in the accuracy of the evaluation. So, here's a few good things about discounted cash flow analysis. It's forward looking, and we do know that when we make a decision to invest in a project or in buying shares in the firm that we are really only interested in what is going to happen next. We are interested in the future. So that means that DCF is better aligned with wealth creation. Second big advantage of DCF is that it focuses on the intrinsic value, on the business operations. That means the analyst needs to gather solid understanding of the source and timing of the cash flows as they accrue to the owners of the firm. It needs to have in depth knowledge of the specific project of the specific firm. It can't just rely on comparables. And lastly DCF tends to be somewhat removed from market irrationality. I'm saying that tongue in cheek because just as markets occasionally display irrational exuberance, so do analysts in accessing the earnings forecast for firms. So there's a relative advantage there, but it might not be huge. But here's the things that are potentially not so good about discounted cash flow analysis. It makes many assumptions. The analyst has to establish a large set of inputs. The technology is what we label computationally intensive. At least when it's done properly, it needs to use detailed information on earnings. That information is, as we've already discussed not always reliable, the accounting information, and is always noisy, meshed with error. Third, discounted cash flow depends crucially on growth and risk assessment. That's again, a big ask. And lastly, remember that we are assuming that the markets get it wrong, from time to time, but eventually the markets will revert back to the true intrinsic value of the project of the firm. There is in fact no guarantee that the market will do that any time soon. Market values might diverge from DCF value for long periods of time. How does that affect the go/no-go decision? And here's a longer list of potential problems with discounted cash flow. It just doesn't work for any firm or just doesn't work for every firm. Firms that have current negative cash flows don't lend themselves well for discounted cash flow valuation. Firms that do not have a history of cash flows are not easily valued within the DCF context. We simply do not have the history to form reliable expectations for future cash flows. Firms that lack a proper risk profile, where we can't get our finger on the riskiness on those future cash flows, at least the risk profile that can be captured by a probability distribution, which would allow us to get a better grip on the discount rate. Firms that are in financial distress, are typically very poorly approximated in value by discounted cash flow analysis. And firms that are entirely new business lines for, or projects that are an entirely new business line, for the firm that we are valuing. And lastly firms that structurally changed in terms of their business operations. Any of these examples would struggle to get an appropriate valuation through DCF application. So again, DCF has got benefits, but it doesn't always work. It depends on the circumstances of the firm, of the cash flows that we are valuing. So just a final word of warning, if the inputs are no good, don't expect the outputs to give you good guidance.
