Your boss uses the discounted free cash flow model to value high growth stocks with low earnings. Do you agree with this strategy? Why or why not?
2 Answer(s)
Sarika
The discounted cash flow valuation model is very popularly used in the industry more specifically to value companies that have a predictable history of positive cash flows. There are 2 kinds of companies. Number 1 - early stage start-up, high growth kind of companies and number 2 - late stage more mature slightly lower growth kind of companies. DCF is most popularly and should be mostly used to value the second kind of companies which are more stable than the post growth stage. The reason for this is when a company is a much smaller high growth company, the cash flows of the company are very volatile they could be many one time events in the life cycle of a company. And since DCF is already a valuation method that has lower assumptions in it, such as one time expenses or revenues that could effect cash flow could have a significant impact on the DCF for the discounted cash flow.
Also the discounted cash flow uses many many assumptions to project the future operations of a company. In a high growth low earnings company there is very little historical data to base these assumptions on and hence it is highly possible for most these assumptions to be wrong and hence the final valuation number could be very off track compared to the valuation of the company, hence for this reason it is not advisable to use the discounted free cash flow model to value high growth low earnings companies but instead other valuation models like comparable trading and comparable acquisition may be used.
Nov 01 2013 12:41 PM
The discounted cash flow valuation model is very popularly used in the industry more specifically to value companies that have a predictable history of positive cash flows. There are 2 kinds of companies. Number 1 - early stage start-up, high growth kind of companies and number 2 - late stage more mature slightly lower growth kind of companies. DCF is most popularly and should be mostly used to value the second kind of companies which are more stable than the post growth stage. The reason for this is when a company is a much smaller high growth company, the cash flows of the company are very volatile they could be many one time events in the life cycle of a company. And since DCF is already a valuation method that has lower assumptions in it, such as one time expenses or revenues that could effect cash flow could have a significant impact on the DCF for the discounted cash flow.
Also the discounted cash flow uses many many assumptions to project the future operations of a company. In a high growth low earnings company there is very little historical data to base these assumptions on and hence it is highly possible for most these assumptions to be wrong and hence the final valuation number could be very off track compared to the valuation of the company, hence for this reason it is not advisable to use the discounted free cash flow model to value high growth low earnings companies but instead other valuation models like comparable trading and comparable acquisition may be used.