Discounted Cash Flow Analysis

Every so often I read an article about how discounted cash flow ("DCF") analysis produces an unreliable stock value due to all the assumptions involved -- in terms of baseline/normalized earnings, discount rate, growth rates, termination values, etc. -- and how small changes in these assumptions can dramatically impact the present value of future cash flows. 

I think there's great danger in an investor trying to determine one stock value based on DCF analysis, and then making a purchase decision based on this one figure. An investor who computes one DCF value never discovers the impact of changes to his assumptions; these changes may make the investor's one estimate of stock value less helpful/realistic than it first appears.

DCF analysis becomes more valuable and realistic when it's used to compute a range of possible values based on worst, normal, and best case scenarios. When a stock is priced below a conservative worst case scenario, then DCF analysis is helpful in determining whether the stock is undervalued, especially when combined with an examination of financial ratios like price to earnings, price to free cash flow, and/or price to book.

The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock.