Mistakes in Discounted Cash Flows (DCF)

There are many mistakes one has to be aware of during the discounted cash flow model of valuation; forecast horizon to make sure the investor selected the right amount of time; beta value to see if the correlation is correction and it is being associated to the right market; equity risk premium which should be correct and growth rate which should neither be too optimistic nor pessimistic.

Mistakes in Discounted Cash Flows

Mistakes in Discounted Cash Flow! How much can it affect your analysis? The answer is a bit, YES! Yes, we make Valuation models, but are we 100% correct? Even small mistakes can hugely affect your analysis.

So let’s try to decode some major mistakes in discounted cash flow analysis. In this article, we discuss the following –

Mistakes in Discounted Cash Flows (DCF)

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Source: Mistakes in Discounted Cash Flows (DCF) (wallstreetmojo.com)

Before directly jumping to the list of mistakes, the following are the infographics that highlight all essential steps to DCF Analysis. This is just to brush up some crucial terms in DCF analysis. This will help you while we are looking at the mistakes in the further part.

DCF Infographics: Steps by Step Analysis

Steps to DCF AnalysisOk, so moving forward to our main topic of discussion.

What can be the impact of mistakes in discounted cash flow analysis?

To know this, I have performed a “Two” DCF analysis of the same company.

  • Analysis 1: No Mistakes in Discounted Cash Flow
  • Analysis 2: Mistakes in Discounted Cash Flow

If you compare these two analyses, there are small changes deliberately made in certain values. This will help us to know the impact of Mistakes on the Intrinsic share price and BUY/SELL recommendation

Following is my final output from the Discounted Free Cash Flow Analysis. Check out the difference in the share price.

You can download the excel sheet containing formulas and calculations for with and without mistakes discounted cash flow analysis.

Mistakes in DCF

#1 No Mistakes in Discounted Cash Flow

No Mistakes in Discounted Cash Flow

#2 Mistakes in Discounted Cash Flow

Mistakes in Discounted Cash Flow

#Mistake: Getting a Sell recommendation in spite of a strong Buy!

This is how the recommendation analysis works.

  • It’s a BUY Recommendation, when: Intrinsic Share Price > Current Market Price (is Greater than)
  • It’s a SELL Recommendation, when: Intrinsic Share Price < Current Market Price (is Less than)

In our case, Results were as follows:

  • No Mistakes in Discounted Cash Flow gave a BUY Recommendation as = Intrinsic Share Price > Current Market Price, as 1505 > 1153
  • Mistakes in Discounted Cash Flow gave a SELL Recommendation as Intrinsic Share Price < Current Market Price, as 418 < 1153.

You must be curious about which mistakes did I make? How are the Intrinsic Values differing so much? Now, presenting the mistakes that I deliberately made in the Discounted Cash Flow Analysis. Let’s analyze them one by one.

  1. Forecast Horizon: Too Much or Too Less!
  2. Cost of Capital: A Challenge?
  3. Growth Rate Assumptions: Extreme?

DCF Mistake#1 – Forecast Horizon: Too Much or Too Less!

Consider that you are valuing an FMCG based company. But you perform financial projectionsPerform Financial ProjectionsFinancial projection is a statistical forecast of a company's future revenue and expenditure based on historical market patterns, internal factors, data interpretation, anticipated market developments, and experiences. To meet production or sales targets, both short-term and long-term financial estimates are sometimes evaluated.read more for only two years. Do you think that it is the right approach? Definitely not!

A time frame of at least five to seven years needs to be considered while performing DCF analysis. But this does not mean that you consider the time frame of 50 years, that would be absolutely wrong.

Imagine the interest rates, economic factorsEconomic FactorsEconomic factors are external, environmental factors that influence business performance, such as interest rates, inflation, unemployment, and economic growth, among others.read more, inflation after 50 years! And we do not have any financial superpower to predict the same. So from now on, for each of the mistake, we will list down specific values taken for:

Forecast Horizon – Without Mistakes

We have considered the forecast period of 5 years for the analysis.

Forecast Horizon – With Mistakes
  • Forecasting is done only for a period of 2 years.

Considering a short forecast period does not give you the effect of different parameters in the coming years. It largely affects the intrinsic share price.

Hence it is essential to take a proper explicit period that is not too short or not too long.

Forecast Horizon

DCF Mistake#2 – Cost of Capital: A Challenge?

Many DCF modes are built on the non-sensible cost of capital. This is one of the significant mistakes in Discounted Cash Flow.

Here is the reason why.

We will now analyze the effect of two important considerations of the CAPM, in our analysis: Beta & Equity Risk Premium

#1 Beta:

This is what Beta is:

  • Beta reflects the sensitivity of a stock’s price movement relative to the broader market.
  • A beta of 1 suggests that the stock tends to move in line with the market.
  • A beta below 1 means that the stock moves less than the market.
  • A beta above 1 implies that the stock moves greater than the market.
  • Beta, though it sounds wonderful in theory, it fails practically and empirically.
  • Ideally, we want forward-looking betas, which is difficult to estimate reliably.
  • Beta’s empirical failure shows how beta does a poor job explaining returns.
Beta Value – Without Mistakes:
  • We have taken the Beta value from a trusted source https://www.reuters.com/.
  • In our case, the beta value fetched from Reuters for the company is 0.89
Beta Value With Mistakes:
  • The beta value is randomly considered.
  • Thus the Beta Value, in this case, is 1.75.Beta Value

#2 Equity Risk Premium:

  • The second important input of CAPM, which can cause errors, is the equity risk premium.
  • Like the Beta, the equity risk premium is a forward-looking estimate.
  • Relying on past equity risk premium values may not give a reasonable sense of the return outlook.
  • Research also suggests that the equity risk premium is possibly non-stationary.
  • Thus using past average values can be very misleading.
Equity Risk Premium – Without Mistakes:

Understand the following:

  • The risk-free rate is the rate of return on your investment with no risk and no loss.
  • Generally, the Government Bond rate is considered in this case.
  • Search, and you will easily get the risk free rate value for the Government bond.
  • The Indian Government Bond rate that I fetched was 7.72%.
  • As an investor in the Stock Market, the general expectation is to get more returns than the risk-free rate.
  • Let’s consider the return expectations between 10%-15%.

According to the Capital Asset Pricing Model, the Formula for calculating the calculate the required rate of returnCalculate The Required Rate Of ReturnRequired Rate of Return (RRR), also known as Hurdle Rate, is the minimum capital amount or return that an investor expects to receive from an investment. It is determined by, Required Rate of Return = (Expected Dividend Payment/Existing Stock Price) + Dividend Growth Rateread more:

=Rf + β(Rm-Rf), Where,

  • Rf is the risk-free rate
  • β is the Beta Value
  • (Rm-Rf) is the equity risk premium

So if the investor is expecting 12% returns, let’s see how the values will fit in our formula:

To make the LHS equal to RHS:

12%= 7.72%+0.89*(?)

(?)= 4.81

Thus the equity risk premium, in this case, is 4.81

Assuming a percentage in the range of 4.5%-5.5% may give you the proper value.

In our correct analysis, I have taken the equity risk premium of 5%.

Equity Risk Premium – With Mistakes:
  • The equity risk premium is randomly considered.
  • Thus the Value, in this case, is 8%.
Equity Risk Premium

DCF Mistake#3 – Growth Rate Assumptions: Extreme?

  • Consider yourself as an insurance agent. You are able to get many customers; you have overachieved your targets. But how?
  • By promising the clients aggressive returns of 30%, with a surety of cumulative increase each year;
  • You were able to fool the clients, but can you fool yourself?
  • You cannot guarantee your clients with some extreme growth figures. Things do not work like that.
  • You have to take into account all the possible factors that affect the growth rate.

The same is the case when you build your DCF model.

Generally, the long term growth rate assumptions are taken wrong. These assumptions are taken to determine the terminal valueThe Terminal ValueTerminal Value is the value of a project at a stage beyond which it's present value cannot be calculated. This value is the permanent value from there onwards. read more component of the DCF valuation.

You have to bear in mind that, long-term rate of growth should not exceed the sum of inflation and real GDP growth at the most.

Growth Rate – Without Mistakes:
  • Growth rate assumptions should always be considered less than the country’s GDP.
  • Taking this into consideration, I have taken the growth rate to 5%. (Less than India’s GDP, which is in the range of 7%)
Growth Rate – With Mistakes:

An extreme Growth percentage of 8% assumed. (More than the GDP growth rate).

Growth Rate Assumptions

These are some common mistakes made in the discounted cash flow analysis. This will help us to analyze the extent of differences in the values. So let’s sum up the differences in our Analysis. These are the results that we got:

Intrinsic share price
  • With Mistakes: 418
  • Without Mistakes: 1505
BUY/SELL recommendation
  • With Mistakes: SELL
  • Without Mistakes: BUY
The difference in the values from the actual analysis

=(1505-418)/1505 = 72% (HUGE!)

Apart from these above-stated mistakes, we have some other common errors as listed below:

  1. Unbalanced assumed investment and earnings growth.
  2. Other liabilities: Inappropriate considerations
  3. Changes in Numbers
  4. Double counting the values
  5. Real and Nominal Cash Flows
  6. Understanding the Market Conditions
  7. Tax rate errors

The above list is taken from  http://www3.nd.edu/

#1 Unbalanced assumed investment and earnings growth.

The source of this mistake is as follows:

  1. For Companies that have been highly acquisitive in the past, Analysts consider the same growth rate now, even if the company is not that much into acquisitions.
  2. One can overcome this mistake by carefully considering the growth rate that is likely to come from today’s business.

#2 Other liabilities: Inappropriate considerations

Another mistake in Discounted Cash Flow is with respect to other liabilities.

Also, check out Restricted Stock UnitsRestricted Stock UnitsRestricted Stock Units or RSU can be defined as stock-based compensation that is issued as company’s stock to an employee. The company establishes vesting requirements based on the performance of an individual and the length of the employment.read more

#3 Changes in Numbers

  • Sometimes small changes in assumptions can also lead to massive changes in the value.
  • Investors should also look to the value drivers like sales, margins, and investment needs as sources of variant sensitivity.

#4 Double counting the values

  • Always make sure that your model does not get into the mistakes of double counting. Now you must be wondering what exactly is double counting. So let’s understand it in simple terms.
  • Double counting simply means that some values are taken twice, causing errors in the model.
  • Your intrinsic share price changes by considering the values twice;
  • Double counting can also take place while considering the risk factor.
  • There are two ways of taking into account the uncertainty of the future:
  1. Directly adjusting the cash flows in the model.
  2. Considering a discount rate;
  • Hence if adjustments are made in both the above methods, it can lead to double counting of the risk, thus leading to an error.

#5 Real and Nominal Cash Flows

Let’s understand the difference between real and nominal cash flows.

  • Nominal: Cash flows that incorporate the effects of inflation
  • Real: Cash flows that exclude its effects are on a real basis.
  • Thus, where real cash flows are used, the impact of inflation needs to be considered in the discount rate.
  • Often errors are seen here as no adjustments are made.

#6 Understanding the Market Conditions 

  • In some cases, income and operating statements for a particular project do not reflect normal operating patterns.
  • Thus ultimately, this will have an effect on your DCF model and the intrinsic share price.
  • In such a case, it is necessary to reconstruct the actual operating statements to reflect market conditions.
  • Projected operating or income statements must attempt to reflect actual market conditions.

#7 Tax rate errors

Mistakes in Discounted Cash Flows (DCF) Video

Conclusion


Since you are now aware of all the probable things that can go wrong in DCF calculations, be well prepared. It is essential to ensure that the assumptions are economically sound as well as transparent. Even the slightest of change in assumptions in Cost of Capital, growth rates, etc. can change the recommendation from BUY to SELL or vice-versa. Please remember that very few DCF models pass the NO MISTAKE DCF test.

Now that you have gained some insights into “Mistakes in Discounted Cash Flow”, I hope that your Analysis will stand apart. Happy Valuations!

Reader Interactions

Comments

  1. khoa do says

    Hi Dheeraj,

    Can yo explain why you calculate the share price base on FCFF not FCFE?

    Thank you

    • Dheeraj Vaidya says

      Hi Khoa, FCFF is more common approach for calculating the share price. There are certain limitations while applying FCFE and hence it is not preferred in most cases. You can look at a detailed note here on FCFE

  2. alex Wang says

    so good article

    • Dheeraj Vaidya says

      thanks Alex.

  3. Syed Muhammad Haider Hussain says

    I must say, the article is very helpful, with easy to understand structure and in depth analysis.
    The growth rate must be less than GDP, and the interpretation of beta less than equal to and greater than 1, these are the new things you added in my knowledge
    Thanks sir dheeraj.

    • Dheeraj says

      Thanks Syed! :-)

  4. Ishrak says

    Your blog has some very good posts and I like this blog! It certainly helps people to get a good understanding of most of the topics and confusions that arises with these topics!Thank u very much but a little bit more publicity is needed.Good luck!

    • Dheeraj says

      Thanks Ishrak, maybe you can help me in marketing this blog.

      Best,
      Dheeraj

  5. BABU says

    Can u provide detailed calculation for terminal value? How to calculate terminal value for FCFF & FCFE? Please explain in writing also.

    • Dheeraj says

      Hi Babu,

      I have written an article on Terminal Value. Hope you find this useful.

      Thanks,
      Dheeraj

  6. Hij Pacete says

    Hi Dheeraj.
    Thank you.
    I really learned a lot from you website.

    • Dheeraj says

      Many Thanks Hij! I am glad you like this website.

      Best,
      Dheeraj

  7. Fikri Syaryadi says

    Thank you Mr. Dheeraj. This really helped me.

    • Dheeraj says

      Thanks Fikri :-)

  8. Akanksha says

    Thanks dheeraj very nice article.

    • Dheeraj says

      Thakns Akansha :-)

  9. udit agrawal says

    Hi Dheeraj

    can u plz share the DCF analysis with excel templates.

    it would be highly appreciable

    Thanks
    Udit Agrawal

    • Dheeraj says

      Hi Udit,

      Soon, i will be coming up with a complete DCF tutorial. It is taking a bit. Will update you shortly.

      Best,
      Dheeraj

  10. Devansh Lakhani says

    Very good article.

    • Dheeraj says

      thanks Devansh!

  11. Mike says

    Hey Dheeraj, just wanted to say I’m really thankful for your website. I’m new to DCF valuation and I’ve learned a lot here. Everything is nicely broken down into easy-to-follow steps with great visuals.

    • Dheeraj says

      Hey Mike, many thanks for your kind appreciation :-)

      Best,
      Dheeraj

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