The DCF and the multiple revenues are popular metric valuations. When investors are analyzing the stock of a company, they can get torn between the two methods. Investors always want to protect their interest. They are less involved in the management of a company hence they must critically evaluate the stock of a company to ensure that their interests are protected. It is essential to look at the various methods available in stock valuation and determine the most appropriate.
The multiple revenues main strength is the simplicity. The multiple revenues are mainly ratios such as the price to sales, and EBITDA/EV.
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These ratios only require one to have basic mathematic skills to calculate. The simplicity of the multiple revenues makes it an appropriate valuation method. Investors can easily get their results, and once they calculate ratios, they will know what each of the ratios means. For instance, a high enterprise value will mean that the company is better than the company with a lower enterprise value.
On the contrary, DCF is a complicated valuation method. It requires a lot of calculations. In the DCF method, the discounting rate must first be estimated to make the appropriate forecasts. Calculating the discounting ratio requires one to have more than the basic mathematic skills. Additionally, DCF will involve discounting of some cash flows. For instance, if a project will run for over ten years, each year’s cash flow will be discounted to estimate the expected returns. The DCF method may require an investor to use the various mathematical applications to determine the value of the stock.
Both the DCF and multiple revenues rely on various assumptions. When calculating the multiple revenues, the average of the various comparable ratios is used to determine the multiple revenues. The multiple revenues use the peer group method to get an average. The peer group method assumes that the market has correctly valued the peer group. This assumption can cause the valuation to have some errors causing some companies to be undervalued or undervalued. Similarly, the DCF relies on various assumptions. To estimate the discounting rate various assumptions are made. Some of the assumptions include the expected rate of return. Relying on assumptions makes both of the methods susceptible to error. The two methods cannot give an accurate picture because of the assumptions and investor should always make some allowances when using the two methods. Alternatively, investors will use these methods alongside other methods to lower the rate of error.
The DCF is a preferred method of valuation because it focuses on eliminating the risk of investing. When investors invest today, they will expect to get high returns in the future. The DCF is useful in estimating the expected value of investment in the future. It uses the discounting rate to get the expected rate. As a result, it eliminates the risk of uncertainty. Investors can invest in long term project comfortably if they feel that they will get high returns in the future. Additionally, the DCF method allows investors to measure the performance of the stock over time. Investors can always look at forecasted cash flows against the actual cash flows and determine if the stock is moving in the expected direction. If the expected cash flows have a huge difference from the actual performance, the investors can use their influence on companies to improve the performance of the stock and make the necessary corrections. The DCF can be used to value volatile stock.
By dealing with uncertainty issues, investors can invest in volatile stock by estimating the returns they will expect given the volatility of the stock. The multiple revenues are the simplified version of the DCF. Similarly, the multiple revenues are less volatile and can be used to evaluate various stocks. The multiple revenues are not easily influenced by the economic factors. However, the multiple revenues cannot forecast the expected returns of stock in the future. It uses various ratios to analyze the stock of a company. Hence it does not concentrate on the cash flows. The DCF main aim is to get the expected returns hence it concentrates on the expected cash flows of the stock.
The multiple revenues are subjective, and it can provide different conclusions. The multiple revenues are composed of different ratios which may have different interpretations given the context. On the other hand, the DCF is a straight forward method that provides clear results. For instance, if an investor is dealing with five-year project and expects their initial investment in the first two years. They can use the discounting rate to determine if it is possible to get the initial investment in the first two years. Therefore, it gives a clear indication and results. On the contrary, the revenue multiple depends on various factors hence the same ratio may provide similar results but mean differently given the context.
The DCF is criticized because it affects the company value. The DCF includes discrete cash flow projections for a period of ten to five years. At the end of this period, the value of the business is then estimated using the multiple. Alternatively, the value is determined by assuming that the company grows at a constant rate. The value of the company at the end of the period is known as the terminal value. The terminal value compromises the true value of the company because it simply assumes that the company growth rate was constant which may not be the case. As a result, the true value of the company can either be undervalued or overvalued.
Multiple Revenues vs DCF - Conclusion
The multiples are closely related to the DCF. Both methods have their strengths and flaws. In stock, valuation it is more effective compared to multiples. Though it involves complicated calculations, it is useful in dealing with risks and uncertainties. As a stock valuation metric, it gives the investor the expected returns. Additionally, it allows investors to have a basis of comparison. They can compare the forecasted information with the exact result and monitor the progress of stock.
