Question

What are the limitations of stock valuation?

Answer 1

The Popular methods of Stock Valuation are

• Dividend Dicount Method (DDM)
• Discounted Cash Flow Method (DCF)
• Comparable Companies Analysis

Limitations of Dividend Discount Method

1. The first drawbackk of the DDM is that it cannot be used to evaluate stocks that don't pay dividends, regardless of the capital gains that could be realized from investing in the stock. The DDM is built on the flawed assumption that the only value of a stock is the return on investment (ROI) it provides through dividends.
2. Another shortcoming of the DDM is the fact that the value calculation it uses requires a number of assumptions regarding things such as growth rate, the Required Rate of Return and Tax rate.One example is the fact that dividend yields change substantially over time. If any of the projections or assumptions made in the calculation are even slightly in error, this can result in an analyst determining a value for a stock that is significantly off in terms of being overvalued or undervalued.
3. The Third drawback of DDM is that it ignores the effects of stock buybacks, effects that can make a vast difference in regard to stock value being returned to shareholders. Ignoring stock buybacks illustrates the problem with the DDM of being, overall, too conservative in its estimation of stock value. Meanwhile, tax structures in other countries make it more advantageous to do share buybacks versus dividends.

Limitations of Discounted Cash Flow Method

1. The First drawback is the operating cash flow projections,there is huge uncertainty with cash flow projection increases for each year in the forecast and  DCF models often use five or even 10 years worth of estimates. we may have a good idea of what operating cash flow will be for the current year and the following year, but beyond that, the ability to project earnings and cash flow diminishes rapidly.
2. The Second drawback is the Capital Expenditure Projections,  Capital expenditure assumptions are, therefore, usually quite risky. While there are a number of techniques to calculate capital expenditures, such as using fixed asset turnover ratios or even a percentage of revenues method, small changes in model assumptions can widely affect the result of the DCF calculation.
3. The third Drawback is the discount rate and growth rate assumptions

Limitations of Comparable Company Analysis

1. It is difficult to identify transactions or companies that are comparable. There is usually a lack of a sufficient number of comparable companies or transactions
2. It is less flexible compared to above methods.
3. The method raises questions on how much data is available and how good the data is.