Question

(j) Are there other equity valuation models? Please discuss the advantages and disadvantages of different equity valuation models.

Answer 1

Discounted cash flow model

Pros

• DCF offers the closest estimate of a stock’s intrinsic value. It’s considered the most sound valuation method if the analyst is confident in his or her assumptions.
• Unlike other valuation methods, DCF relies on free cash flows, considered to be a reliable measure that eliminates subjective accounting policies.
• DCF isn’t significantly influenced by short-term market conditions or non-economic factors.
• DCF is particularly useful when there’s a high degree of confidence regarding future cash flows.

Cons

• DCF valuation is very sensitive to the assumptions/forecasts made by the analyst. Even small adjustments can cause DCF valuation to vary widely – which means the fair value may not be accurate.
• DCF tends to be more time-intensive compared with other valuation techniques.
• DCF involves forecasting future performance, which can be very difficult, especially if the company isn’t operating with 100% transparency.
• DCF valuation is a moving target: If any company expectations change, the fair value will change accordingly.

Free cash flow models

Here Are the Pros of Free Cash Flow

1. It offers a close, intrinsic stock value.
Comparing stocks is something that investors do every day. Many of the valuation metrics are relative, however, like the price-to-sales ratios that dominate the internet today. These metrics are used because they’re easy to calculate, but the problem is that they aren’t always accurate. One false estimate can make a bad stock look good. Free cash flow allows investors to have a close, intrinsic stock value, allowing for a better decision.

2. It is a trustworthy measurement.
In the world of investing, there is nothing worse than the “guesstimate.” Not only is the estimate a guess, but in the “guesstimate,” there is even guessing at what the estimate should be. It would be just as feasible to take your investment capital to a casino, find the closest roulette table, and bet it all on red. Free cash flow is a trustworthy measurement that eliminates the guesswork because the reported earnings can be evaluated with more accuracy.

3. It provides the chance to accurately peer into the future of a company.
All an investor needs to do is work backwards from the current stock price and cash flow model to determine how fast a company will need to grow. This lets people know where the real value of a company happens to be and if the stock price of that company is over- or under-valued by the market right now.

4. It helps to reduce uncertainty.
Nothing can completely eliminate uncertainty when it comes to investing. What free cash flow does is help the investor be able to separate the stocks that make sense from the stocks that are most likely going to create a loss. By being able to reduce the overall risks involved, the investor can look to become as conservative or as aggressive as they want to be when it comes to building their overall wealth.

Here Are the Cons of Free Cash Flow

1. One fact isn’t going to solve every investor problem.
Free cash flow is only as good as the accuracy of the forecasts that are being used to simulate future growth. A lot of things can happen to a company over the course of 365 days. Just look at what happened with 19 Kids and Counting and TLC. One news report caused a $20+ million one-time unexpected charge. Unless a certain percentage of risk is built into the equation, free cash flow is not a one-sized-fits-all solution.

2. It only works when there is visibility.
Free cash flow metrics will only work when a company is operating with 100% transparency. If there are questions about the sales practices, cost trends, and other information that can affect the free cash flow, then there is too much uncertainty to use this measurement as a tool for the investor.

3. It also only works based on the projections created by the investor.
Free cash flow is a good piece of information to have, but the investor is forced to still make assumptions about what will happen in the future. The accuracy of those assumptions will create a projection that either hits the nail on the head… or falls fall short and hits the investor square on the thumb. Being off by just 1 percentage point for some companies can change the financial outlook be tens of millions of dollars.

4. There is no real benefit to long-term investing.
Free cash flow can definitely help the short-term investor, but what about the individual who wants to put some stock into their 401k or IRA for their anticipated retirement in 20 years? This information is of no value to the long-term investor because there are far too many variables that could happen from year-to-year. A classic example of this is Microsoft vs. Apple. In 1995, the free cash flow looked like Microsoft would dominate in the future. Instead Apple is the company breaking all the records and Microsoft is struggling to survive in comparison.

The pros and cons of free cash flow show that for short-term investments, it can be used to achieve better profits. It is more accurate, eliminates guesswork, and is a tangible bit of information that only requires assumptions on longer-term investments. It may just be one method of examining a stock, but the accuracy of this method means it should be consider by every investor.