Discounted cash flow metric and the ability to predict future cash flows
Every investor understands how hard it is to value stock. There are a variety of methods of valuing stock hence it is important for investors to know the strengths and weakness of each approach when valuing stock. The DCF methods and comparable are two methods of metric valuation. This article will compare the two approaches and determine which one is more efficient based on the strengths and weakness of each method.
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The DCF analyzes the important drivers of a business value creation. The DCF is useful when it comes to dealing with the risk of investing in the firm. The value of an investment today will have changed in the next five years. Some factors in the market such as inflation can cause the rate of an investment to change. It is important to account for these changes. In business, the changes are recorded through a discounting rate. The cash flows are discounted based on the rate of discount. As a result, the real return on investment can be determined.
The DCF uses various discount rates to ensure that investor gets their initial investors back within a stipulated amount of time. The advantage of using the DFC is that it considers the volatile and stable stock. Companies with a volatile stock will have a high discount rate. A volatile stock is less predictable. It can quickly change and cause investors to lose their investment. Due to the risks involved in this type of investment, investors demand a high discount rate. Businesses that are stable have a lower discount rate and sometimes a high valuation.
The DCF provides companies with a strong brand with a competitive advantage. Enterprises that have a strong brand and are performing relatively well in the market attract many investors. The companies enjoy economies of scale hence they have an advantage over small enterprises. These companies can sell differentiated products and face minimal competition in the market. To a large extent, the big business creates barriers for new firms to enter the market. The companies gain a competitive advantage in the market and control a considerable amount of the market. As a result, the companies have the ability to generate high returns on capital.
The companies by enjoying a significant market share have the potential to make huge profits. The high level of profitability allows the companies to generate high returns on capital. Investors will prefer to invest in this type of business because they have a high discount rate. The investors expect to get high returns on capital.
The companies are relatively stable, and investors understand that the capital returns will exceed the cost of capital. The DCF indicates the rate of reinvestment of a company. Investors can use the DCF to determine the rate of reinvestment. An organization that has a high rate of return compared to the cost of capital is expected to reinvest the money. Moreover, DCF is useful when estimating the growth rate of a company. It accounts for the future cash flows and returns of capital. It provides investors with real investment growth given the future investment.
The comparable use various elements to make comparisons. In this methods the items used in comparison and formulate an estimated value of the company. Some items used in comparison include price. Some of the comparable methods that are used include the price-to-earnings ratio and price-to-sales ratio. The comparable method has various strengths that make it a useful metric method. It is easy to understand and apply. The comparable mainly use ratio to determine the financial value of a company.
It can take the price and compare it to sales. It is an easy valuation method since it uses the readily available information and an investor will not have to make complicated assumptions. The comparable method is better than the DCF when it comes to capturing the current mood of the market. The comparable can use various industry metric to measure the current performance of the company.
Conversely, the DCF concentrates on discounting future cash flows. It gives an investor a forecasted estimate of the performance of a business and fails to provide the current performance of the company. The comparable has a small number of assumptions. The DCF is mainly based on assumptions such as future cash flows. The discounted rate that is used is an estimated rate that is derived from making various assumptions. Making many assumptions means that the price is subject to various errors.
The DCF is mainly based on assumptions such as return on equity and future cash flows. It is a complicated valuation method because it requires investors to make predictions about future cash flows. However, DCF is a good method for long term investment. It makes use of free cash flows, and it uses different models to estimate the expected growth rate. An investor can determine if the cost of capital will be lower than the return on investment in the future.
The comparable method focuses on the current market hence it can mainly be used by short-term investors who are more concerned about getting returns in the short run. The DCF and comparable methods are useful methods in different scenarios. The DCF method is an effective method when dealing with stable and mature companies. It makes various assumptions, therefore, for the discounted rate to be close to accurate the industry should be stable. On the other hand, comparable methods are effective when valuing companies that rarely pay dividends. Some companies will record a high earning rate but fail to pay dividends.
For instance, Apple started paying dividends after 17 years. The comparable method is a useful method when evaluating this type of a company.
Future cash flows, Comparables and equity valuations
The secret of being a good investor lies in information and less on predicting future cash flows in the year 2050. Investors must always ensure that they get relevant information. Financial data is comprehensive, and an investor may not understand all the information it is important to use proper valuation methods. However, investors should not confine themselves to using a single method. They should use both the DCF for an attempt to get some understanding of future cash flows and the comparable way when faced with a hard investment decision.