Write peer response for following three posts. Each one should be 150-200 words.
Write Peer response for following three posts.
Topic 1: DCF
Although the mathematics of DCF looks so simple and compelling, the implementation of DCF technique becomes a minefield of problems. The problems can be either with estimating cash flows or discount rates. Identify one problem from each and explain the issues. Where appropriate, use current company examples to help illustrate your answer.
First it is important to understand what DCF is exactly. Discounted cash flow is, “a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.” (Fernando, 2020). There are many problems with using the DCF technique.
- based on estimates and assumptions
- high chance of error
- small changes in estimates impact the DCF technique greatly
- “Perhaps the most contentious assumptions in a DCF model are the discount rate and growth rate assumptions.” (Segal, 2020). Both approaches to attaining the discount rate are theoretical and may not be realistic to use.
DCF analysis should be used with other tools to achieve the best and accurate results. There are many problems when forecasting earnings and cash flow. Each year in the forecast adds uncertainty. DCF analysis often uses five to ten years for the estimates. The longer the time period the higher the risk for inaccuracies. The further out the dates the more the values are just random guesses. Cash flow estimates are typically based on results from prior years. This does not factor in environmental (internal or external) factors. Small inaccuracies in the first few years of the analysis create large variances in later years.
Fernando, J. (2020). Discounted Cash Flow (DCF). Retrieved February 16, 2021, from https://www.investopedia.com/terms/d/dcf.asp#:%7E:text=Discounted%20cash%20flow%20(DCF)%20is,will%20generate%20in%20the%20future.
Segal, T. (2020). Top 3 Pitfalls Of Discounted Cash Flow Analysis. Retrieved February 16, 2021, from https://www.investopedia.com/investing/pitfalls-of-discounted-cash-flow-analysis/
As per our textbook, “calculating the present value of a future cash flow to determine its worth today is commonly called discounted cash flow (DCF) valuation.” (Ross, Westerfield, Jordan, & Roberts, 2019) DCF attempts to evaluate a company’s future earnings/value in today’s current value. “These year-by-year projected amounts are then discounted using the company’s weighted average cost of capital to finally obtain a current value estimate of the company’s future growth.” (Segal, 2020)
Issues with estimating cash flow are similar to forecasting challenges. There is no perfect method or formula for forecasting. “A forecast is simply a prediction of what will happen in the future. Managers must accept that regardless of the technique used, they will not be able to develop perfect forecasts” (Anderson, et al., 2015, p. 196) In my experience as a Sales Planner for 9 years, the more historical data I use, the better aligned the sales forecasts are but for projecting cash flows beyond the current and following year diminishes (Segal, 2020).
The DCF assumption of a constant discount rate of, 4% for example, over several years is not very scientific. It’s rare for companies to grow a constant number year over year. “Due to the nature of DCF calculation, the method is extremely sensitive to small changes in the discount rate” (Segal, 2020)
Anderson, D., Sweeney, D., Williams, T. A., Camm, J. D., Fry, M., & Ohlmann, J. (2015). Quantitative Methods for Business 13th Edition. Mason, OH: Cengage Learning.
Ross, S. A., Westerfield, R., Jordan, B. D., & Roberts, G. S. (2019). Fundamentals of corporate finance (10th Canadian ed.). Mcgraw-Hill Ryerson.
Segal, T. (2020). Top 3 Pitfalls Of Discounted Cash Flow Analysis. Retrieved from www.investopedia.com: https://www.investopedia.com/investing/pitfalls-of-discounted-cash-flow-analysis/
Discounted cash flow (DCF) is calculating the present value of a future cash flow to determine its worth today (Ross, Westerfield, Jordan & Roberts, 2019). Estimating cash flows can be especially tricky for stocks because cash flows aren’t known upfront, the investment doesn’t mature and there is no easy way to determine the rate of return required by the market (Ross, Westerfield, Jordan & Roberts, 2019). DCF also does not consider cyclical changes of industry or future capital requirements so it is not an accurate picture of a companies potential (Simply Wall ST, 2021). A further complication to cash flow estimation is that cash flow projections become more irrelevant the further out you go, cash flows are typically based on historical information and cash outflow can be so unpredictable from year to year. As well capital expenditures are often discretionary and thus difficult to predict (Segal, 2020). The problem with the discount rate is choosing the correct one. You need to be sure you are choosing a rate that reflects the industry for which you are valuing (Segal, 2020). Simply Wall St performed a valuation of Spin Master Master Corp that my classmates may find interesting, they describe their method and reasons for choosing the discount rate. It was interesting to see a valuation done. References:
Segal, T. (2020, April 15). Top 3 pitfalls of discounted cash flow analysis. Investopedia. Retrieved February 16, 2021, from https://www.investopedia.com/investing/pitfalls-of-discounted-cash-flow-analysis/
Simply Wall St. (2021, February 16). A look at the intrinsic value of spin master Corp. (TSE:TOY). About Us – Simply Wall St. https://simplywall.st/stocks/ca/consumer-durables/tsx-toy/spin-master-shares/news/a-look-at-the-intrinsic-value-of-spin-master-corp-tsetoy-1
Ross, S. A., Westerfield, R., Jordan, B. D., & Roberts, G. S. (2019). Fundamentals of corporate finance (10th Canadian ed.). McGraw-Hill Ryerson.
Type of service: Academic paper writing
Type of assignment: Essay
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