I have been reading a bit lately that DCF is not used that much on the Buy Side. Why exactly is that? I know one of the points to it is to develop a price target, which I guess is not that much of a concern on Buy Side. Do they use relative analysis more often then? What method do they mostly use in determining value?
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the principle behind a DCF also applies to an LBO model but in the case of a PE shop--they are trying to target a specific IRR to exit the investment.
Agree. Buy side is very IRR focused and when formulating a purchase price for a target, the sponsor's returns are paramount. A margin of safety also has to be built in because we all know things never go as planned
Because it's stupid.
not an expert on this but probably the standard reasons why DCF is bad: 1. projecting cashflows is hard 2. very sensitive to assumptions 3. if your DCF shows massive over or undervaluation, its not going to be a secret to market participants
You project cash flows in the LBO method, as well. As such, there are sensitive assumptions involved.
margin of safety...
if anything, working has made me completely skeptical of financial models. Last summer, I was working my first sponsor deal and the IRR's were just terrible--something like 5-7% even with the min capex, optimistic margin and revenue expansion, etc etc. My VP comes over and says "let me take a look." He toggles a few numbers, plays around with it for 20 seconds, and gets it to jump to 28%. And that's what went into the book.
Wake up homes. In the event you will monetize a position through a sale your presentation to potential buyers will likely include bullish metrics to maximize valuation.
^ Oh, I'm aware. On the sell-side, however, that's pretty much all it is. At least on the buy-side, you get to wear your realist hat when you're evaluating potential investments. Plus, upside is much more visible on the buy-side, making manufacturing BS more tolerable.
Some good answers here already, but my $0.02: equity research it's more about relative valuation--what are you buying/selling in relation to other names than it is about the absolute valuation of a particular company. God knows you need to be aware of the cash flows and significant variations between income and cash, but the incremental cost vs. the benefit of doing a DCF vs. your IS/BS metrics with Dupont breakdown, then comparing across your sector names, is minimal in my humble opinion.
So many names, so many metrics, so much modeling, so little time.
As mentioned by others, DCF is highly sensitive to many assumptions. That said about half the buyside managers I speak to claim to do DCFs on their stocks, and I'd say at least a quarter actually does it consistently.
E.g. a very good question posed to me by one manager: How do you reflect the characteristic of 'quality' in a DCF? Let's say you have two companies, one that you know with almost certainty will earn $100, and one a shoddy business that can have a range of outcomes but with a reasonably certain midrange at $100? The only way to reflect this would be either with some kind of utility function that punishes ex ante volatility (which nobody uses or cares about) or to apply a higher discount rate (and the entire valuation will be extremely sensitive to changes in discount rate which throws up the nice question of which one to apply).
Excellent example spidermonkey, I've never really thought about that. +1
The only problem I have with the DcF is that it gives a be all and end all number.. when I look at stocks I always try to operate in bands of values.
Anyone know where there are examples of DCFs for stocks anywhere online? I know the study guides walk you through a DCF but that's about it
You can create, and when DCFs are used in the real world they almost always are created, a band of values. You can do multiple operating scenarios, sensitize the WACC, sensitize the TV multiple, use a different TV multiple, use a growing perpetuity, etc., etc. etc.
There's really no end to what you can do to a DCF, which is probably the reason it is less used.
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