DCF valuation
A discounted cash flow (DCF) is the most fundamentally correct way of valuing an investment. Most other methods of valuation can, to a large extent, be seen as simplified approximations of a DCF. A DCF valuation requires making many estimates and assumptions which introduce a lot of uncertainty and it is therefore often simply not worth doing.
The value of an asset is the value of the future benefits it brings. The value of an investment is that cash flows that it will generate for the investor: interest payments, dividends, repayments etc.
These cash flows need to be adjusted for two things:
- the time value of money
- the risk that the amount of money will not be what is expected.
In a DCF valuation, a discount rate is chosen which reflects the risk (the higher the risk the higher the discount rate) and this is used to discount all forecast future cash flows to calculate a present value:
PV = (CF1)/(1+r) + (CF2)/((1+r)2) + (CF3)/((1+r)3) ⋅⋅⋅
where PV is the present value of the stream of cashflows
CF1 is the cashflow the investor receives in the first year, CF2 the cashflow the investor receives in the second year etc. and
r is the discount rate.
In the case of bonds, the cash flows would be interest payments and repayments. In the case of shares, the actual cashflows investors receive are dividends, but there are other cash flows that can be meaningfully discounted instead.
CAPM can be used to calculate the discount rate r, used in the calculation above. Unless the series of cash flows has a known finite endpoint a terminal value will need to be assumed.
DCF valuation methods for shares
As mentioned in passing above, the actual cash flows shareholders receive, and therefore the obvious cash flows to discount are the dividends. This is also theoretically the most correct thing to do. The problem with discounting dividends is that not only do you have to forecast the performance of the company, you also need to guess its future dividend policy.
As the money made by a company belongs to its shareholders regardless of whether it is paid to them or not, we can avoid having to guess at dividend policies by instead discounting the company's earnings. So can we discount the EPS? We cannot, because retained earnings are invested and boost future earnings. Simply discounting future EPS would lead to double counting.
Profits do no necessarily bring in cash to the company (as profits are calculated using the accrual principle). Therefore it makes sense to discount cash flows instead. If we discount free cash flows we also get rid of the double counting problem. Financial theory would also suggest that unless a company has very high return opportunities for expansion (or is investing very badly) then the difference in valuation between a dividend discount valuation and a free cash flow discount valuation will be comparatively small.
Relationship with valuation ratios
Two companies with the same growth prospects, similar profitability, similar debt levels (relative to profits) and trading at a price which reflects the same discount rate, would then be on similar PE ratios. Even if debt levels were different they would have similar EV/EBITDAs.
This is why companies in the same sector should have similar valuation ratios unless there are differences in the risks they face or their growth prospects. Investors should look for the reasons for the differences in rating between a company and its nearest peers and decide whether there are sufficient reasons to justify the difference — or if the difference should be be bigger.
Differences in valuation ratios should ultimately reflect differences in growth or risk that would also be reflected the same way by a DCF. Even investors who do not use DCF valuations should keep them in mind. For all their faults, they are fundamentally correct.