Advantages
| Disadvantages
|
Easy to understand and apply Fewer assumptions used than with DCF Better captures current mood of market
| Choice of multiples sometimes subjective Difficult to find comparables with identical, or at least similar, revenue drivers Assumption that market accurately values the peer group
|
Which Model to Use
The choice between these two alternative valuation models will depend on specific factors, such as availability and accuracy of the inputs (revenue drivers,businesscycles, etc.).
Dividend-Paying, Mature and Stable Companies
The DDM model is best applied for stable and mature public companies that pay dividends. For example, BP plc. (BP), Microsoft Corporation (MSFT)and Wal-Mart Stores, Inc. (WMT) pay regular dividends and can be characterized as stable and mature businesses. Therefore, the DDM can be applied to value these companies.
The FCF model can be used to calculate the valuation of companies that do not pay dividends or pay dividends in an irregular fashion. This model is also applied for those companies with a dividend growth rate that does not properly capture the earnings growth rates.
Companies with Diverse Revenue Drivers
When a company valued has a diversified revenue source, the free cash flow method can be a better approach than the comparable method, simply because finding a true comparison can be problematic. Today there are a number of large-cap companies with diversified revenue drivers. This feature makes it challenging to find a relevant peer group, company, or even industry multiples.
For example, both Canon Inc. (CAJ) and Hewlett-Packard Company (HPQ) are large manufacturers of printing machines for business and personal use. However, HP’s revenue also is derived from the computer business. HP and Apple are both competitors in the computer business, but Apple derives its revenue mostly from sales of smartphones and its built-in app store.
Apparently, neither Canon and HP, nor HP and Apple, can be in a peer group in order to use a peer group multiple.
Valuation of Private Companies
There is no straightforward choice of valuation model for private companies. It will depend on the maturation of the private company and the availability of model inputs. For a stable and mature company, the comparables method can be the best option.
In general, it is very complicated to get the inputs required for the DCF model from private companies. The beta, which is one of the key inputs for a returns estimation of a private company, is best estimated using comparable firms’ betas. This makes it challenging to apply the DCF model.
Private companies do not distribute regular dividends, and therefore, future dividend distribution is unpredictable. The free cash flow model would also be unreliable for valuing relatively new private companies due to the high uncertainty surrounding the business itself. However, in the early stages of a private company with a high growth rate, the FCF model may be a better option for common equity valuation.
Valuation of Cyclical Companies
Cyclical companies are those that experience high volatility of earnings based on business cycles. This can lead to difficulties in forecasting future earnings. Forecasting earnings is a base for theDCF models (be it DDM or FCF model). The relationship between risk and return implies that increased risk shall be accounted for in an increased discount rate, making the model even more complicated. As a result, if an investor chooses the DCF model to value a cyclical company, they will most likely get inaccurate results.The comparable method can better solve the cyclicality problem.
The Bottom Line
A mix of factors impacts the choice of which equity valuation model to choose. No one model is ideal for a certain type of company.Ideally, both models should yield close results, if not the same. The DCF model requires high accuracy in forecasting future dividends or free cash flows, whereas the comparables method requires the availability of a fair, comparable peer group (or industry), since this modelis based on the law of one price, which states that similar goods should sell at similar prices (thus, similar revenues earned from the similar sources should be similarly priced).
FAQs
The DCF model requires high accuracy in forecasting future dividends or free cash flows, whereas the comparables method requires the availability of a fair, comparable peer group (or industry), since this model is based on the law of one price, which states that similar goods should sell at similar prices (thus, ...
What is discounted cash flow How does it differ from comparables? ›
Future vs. Current Value: DCF focuses on future cash flows, projecting company performance, while Comparable Companies Analysis assesses the company's current value relative to similar firms.
Which is better, DCF or relative valuation? ›
Discounted cash flow valuations, with their long lists of explicit assumptions are much more difficult to defend than relative valuations, where the value used for a multiple often comes from what the market is paying for similar firms.
When should you not use a DCF? ›
The main Cons of a DCF model are:
Very sensitive to changes in assumptions. A high level of detail may result in overconfidence. Looks at company valuation in isolation. Doesn't look at relative valuations of competitors.
What is the biggest drawback of the DCF? ›
Disadvantages. DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won't be accurate.
What is a disadvantage of using the comparables method for equity valuation? ›
Disadvantages. 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. It is less flexible compared to other methods.
When to use DCF vs multiples? ›
Choosing Between Multiples and DCF
It's a high-level view and is often used as a starting point or sanity check in valuation exercises. DCF, however, is better for detailed and comprehensive valuations. It allows for a detailed analysis and is highly sensitive to assumptions.
Why is discounted cash flow the best method? ›
The Bottom Line
Discounted cash flow is a valuation method that estimates the value of an investment based on its expected future cash flows. By using a DFC calculation, investors can estimate the profit they could make with an investment (adjusted for the time value of money).
Which valuation method gives the highest valuation? ›
DCF – The Most Lucrative Valuation Method
Typically, the Discounted Cash Flow (DCF) method tends to give the highest valuation.
When not to use relative valuation? ›
During market extremes, such as bubbles or crashes, relative valuation can result in valuations that are disconnected from underlying economic realities, leading to overvalued or undervalued investments.
There are three major concepts in DCF model: net present value, discounted rate and free cash flow. Estimate all future cash flows and discount them for a present value. Generally, use the discount rate as the appropriate cost of capital.
Is DCF the best way to value a company? ›
Theoretically, the DCF is arguably the most sound method of valuation. The DCF method is forward-looking and depends more on future expectations rather than historical results.
What is the difference between DCF and comparable analysis? ›
Comparable company analysis (or “comps” for short) is a valuation methodology that looks at ratios of similar public companies and uses them to derive the value of another business. Comps is a relative form of valuation, unlike a discounted cash flow (DCF) analysis, which is an intrinsic form of valuation.
How accurate is discounted cash flow? ›
The accuracy of a DCF valuation relies heavily on the reliability of projected cash flows and the chosen discount rate, making it an estimate rather than an exact figure. Consequently, it is subject to considerable uncertainty that requires the sound judgement of a professional.
Which are the situations in which we do not use a DCF in the valuation? ›
Also, since the very focus of DCF analysis is long-term growth, it is not an appropriate tool for evaluating short-term profit potential. Besides, as an investor, it's wise to avoid being too reliant on one method over another when assessing the value of stocks.
When would you use a DCF in a valuation? ›
Discounted cash flow (DCF) is a valuation method that estimates the value of an investment using its expected future cash flows. Analysts use DCF to determine the value of an investment today, based on projections of how much money that investment will generate in the future.
What is the difference between CAPM and DCF? ›
Capital asset pricing model or CAPM is a financial model that measures the risk premium inherent in equity investments like common stocks while Discounted Cash Flow or DCF compares the cost of an investment with the present value of future cash flows generated by the investment with the mindset being that if the cash ...
Why use DCF vs multiples? ›
Choosing Between Multiples and DCF
It's a high-level view and is often used as a starting point or sanity check in valuation exercises. DCF, however, is better for detailed and comprehensive valuations. It allows for a detailed analysis and is highly sensitive to assumptions.
