Conscious Investor Knowledge Base

What are the strengths and weaknesses of Discount Cash Flow DCF methods?

Discount Cash Flow DCF methods were developed in response to a need, to get more objectivity in determining whether a stock was likely to be a good investment or not. They represent an important landmark in this goal of helping serious investors move away from basing decisions on rumor, hearsay and, perhaps, a scan of the financial statements. The aim of DCF methods was to determine the "intrinsic value" of a stock.

DCF methods are still used by almost all analysts and fund managers, who take a value approach to their investment reports and decisions. Just the same, they are so badly flawed that the dangers involved in their use far outweigh any positive points. They should really only be of interest to those who want to know more about the history of calculation-based methods for evaluating investment value.

Flaws in DCF methods include:

(1) They are theoretical formulas. Just because a stock has a high intrinsic value compared to its price, does not mean that it will be a profitable investment in terms of return. For example, it may continue at its current price levels.

(2) There are many DCF formulas all giving different values. A stock could be undervalued according to one formula, but overvalued according to another.

(3) All the formulas are unstable. This means that small changes in the input numbers lead to extremely large variation in the output. A change of a few percent in the input can lead to changes of 100% or more in the output.

(4) It is impossible to test the accuracy of some of the input numbers. For example, you are supposed to enter the growth rate of earnings (or free cash flow) out to infinity.

All these flaws are overcome by the tools in Conscious Investor, particularly through the use of STRET and STRETD.




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Last Updated
30th of June, 2008

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