Estimate the intrinsic value of an investment with widely used Discounted Cash Flow (DCF) models in financial analysis. Many investment funds use the DCF to help them come to various valuations for a potential investment. The DCF is very popular with asset managers and long-only funds to help value an investment over a longer-term holding period regardless of the current market dynamic. Hedge funds use the DCF and other valuation methodologies to help triangulate asset value and help them understand how long-only investments assess value. Even private equity firms and companies may use DCFs to help them understand what other market participants think about the value of an asset. Investment bankers use the DCF to help their clients understand how different investors will value their company. Given all the market participants that use DCFs, this model is one of the key drivers of financial analysis for the valuation of assets.
How Discounted Cash Flows Work
To start, let’s briefly review how a DCF model works. DCF models rely on the age-old concept of the time value of money, which states that a dollar received today is worth more than a dollar received in the future due to the potential to reinvest the money and earn a return. DCF models project the cash flows that an investment generates over a certain period. Depending on the user of the DCF model, these projections may come from the company itself, equity research firms, or a team’s financial model. The investor discounts these cash flows back to their present value using a discount rate that reflects the cost of capital or the investor’s required rate of return. In stock analysis, the weighted-average cost of capital (WACC) typically serves as the discount rate. The present cash flow value represents the investment’s intrinsic value.
The DCF model values a company only using its internal financial metrics and internal assumptions, unlike other extrinsic valuation methodologies like comparable public companies or precedent transactions. It is not affected by external market multiples that fluctuate over time and are influenced by individual company performance and business quality.
However, as you can already see from the brief description, DCF models are based on several assumptions, such as the accuracy of the cash flow projections and the stability of the discount rate, which can be subject to uncertainty and variability.
Therefore, analysts should sensitize their model around assumptions such as growth rates, profitability margins, discount rates, and terminal value to get a full range of pricing for the asset.
How DCFs Affect the Market and Vice-versa
A more interesting point of discussion is how the DCF model drives investors’ financial analysis and the market at large (as well as how the market can affect a DCF model).
Since the price of an asset on the market is simply the agreed open price between buyers and sellers, the price is just a function of the outputs of investors’ and market participants’ DCF models (as well as other valuation models, of course). Therefore, when evaluating the price of an asset, analysts should think about how other analysts are modeling their assumptions to get to a certain price. If the price of an asset seems too low based on your DCF modeling, think about some of the assumptions that other investors may be modeling lower than you to get the current market value. If others are right, you may be too bullish on an asset, and your assumptions should come down too.
The strength or weakness of the current economic cycle also affects DCF modeling. Since a DCF is made up of the future cash flows of an asset, these cash flow projections are typically influenced by the status of the current market backdrop. In times of economic strength and market bullishness, analysts tend to project stronger growth and profitability for assets than what ends up happening. Conversely, analysts tend to underestimate cash flows in weak economic cycles and market bearishness. Mean reversion is a strong natural phenomenon in finance. Yet even the best analysts experience difficulty modeling financials accurately.
While DCFs are intended to be intrinsic to markets, the analysts using them tend to be swayed by economic cycles in their forecasts. Furthermore, analysts may take up or down their projections to justify current prices to meet the current market backdrop. When cycles turn (move from strong to weak or vice-versa), analysts’ DCF models tend to readjust quickly to meet the new market backdrop, driving prices in one direction.
Another significant market driver of DCF models is interest rates. Since future cash flows are discounted at constant interest rate assumptions, changes in interest rates affect the present value of these future cash flows even if the underlying projections do not change. As we had seen over the last year or two, when the Fed raised interest rates, the stock market fell in line, especially with more growth stocks. This is partly because all of the market participants’ DCF models were adjusting their discount rates higher to meet the higher interest rates. Remember, when the discount rate goes up, the present value of future cash flows goes down, and thus the asset value declines. Therefore, DCFs are sensitive to changing interest rate dynamics and Fed policy.
The use of DCF models in financial analysis allows investors to assess an investment’s potential risks and returns and to compare the intrinsic value of different investment opportunities. The model provides:
- A quantitative framework for making investment decisions by considering the expected cash flows
- The time value of money
- The cost of capital
For these reasons, DCFs are widely popular in the financial analyst community. Keep in mind that DCF models have imperfections and require the use of other financial analysis tools and qualitative assessments to make informed investment decisions.
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