3 Overlooked Issues with Discounted Cash Flow Valuation

Everyone knows that a discounted cash flow (DCF) valuation is highly sensitive to discount rate and growth rate assumptions. However, there still remains huge amount of subjectivity, even in inputs which are typically thought to be clear cut. These are the issues which textbooks don’t address.

Risk Free Rate

The risk free rate is a guaranteed rate of return that an investor can earn from any instrument without taking any risk. Government bonds are often thought to be riskless as it is highly improbable for a government to default given their ability to print more fiat money. Of course, as the Eurozone crisis will tell you, not every government is riskless. Therefore, the most often used proxy for the risk free rate is unsurprisingly the U.S treasury bills. But what tenure should one use?

Discounted Cash Flow Valuation
Discounted Cash Flow Valuation

As you can see, the yields between the 5-years and 30 years differ substantially. Considering that the risk free rate is often the most straightforward input in a DCF valuation, it can only get worse from here.

Beta

Beta measures the volatility of a stock price, in relation to the index. Beta figures are often provided by data platforms such as Bloomberg or Reuters. Unfortunately, beta itself is volatile. Pablo Fernandez, in his paper –Are calculated betas good for anything? – calculated the historical beta of 3 major blue chip companies; AT&T, Boeing and Coca Cola.

Discounted Cash Flow Valuation
Discounted Cash Flow Valuation

Within a single year, the betas of these large, global companies can diff by half from peak to trough. On average, he found that the maximum industry beta was 2.7 times its minimum beta between 2001 and 2002, based on a sample of 3,813 companies.

Discounted Cash Flow Valuation – Market Return

Market return is the return an investor can expect to earn if he took on a level of risk equal to the general market. Everyone knows that markets are volatile with its fair share of bull and bear years. How long of a time frame should investors take as an estimate of market return?

Discounted Cash Flow Valuation

If you were an investor in 2005 and you took the historical 10 year (1995-2005) return of the STI index, your market return would have been near zero! Implicitly, you are also saying that the risk free rate is higher than the risky, market return. As you can see from the angle of the different orange arrows, the time frame has a significant impact on the resultant market return value.

Final Words

DCF is often taught as a one-size fits all valuation method that is applicable across many industries. Theoretically, this is true. But the last thing we want is for people to be cavalier and complacent in their (mis)use of the DCF. As anyone who has spent time on a valuation model can tell you, it is possible to come out with any valuation figure from a DCF. It would be a pity for an investor to make a wrong stock purchase based on a far-fetched DCF valuation.