What is discounted cash flow and how does it compare to relative valuation?

1 Discounted cash flow

Discounted cash flow (DCF) is a method that estimates the present value of an asset based on its expected future cash flows. The idea is that an asset is worth the sum of its future cash flows, discounted by a rate that reflects the risk and opportunity cost of investing in it. To use DCF, you need to project the cash flows of the asset for a certain period, usually based on its historical performance, growth potential, and competitive advantage. Then, you need to choose an appropriate discount rate, which can be based on the asset's cost of capital, the market's required rate of return, or other factors. Finally, you need to calculate the present value of the cash flows by applying the discount rate to each year's cash flow and adding them up.

2 Relative valuation

Relative valuation is a method that compares the value of an asset to the value of similar or comparable assets in the market. The idea is that an asset is worth what other investors are willing to pay for it, based on its relative performance, quality, and risk. To use relative valuation, you need to identify a set of comparable assets that have similar characteristics, such as industry, size, growth, profitability, or risk. Then, you need to choose one or more valuation multiples, which are ratios that express the value of an asset relative to a key financial metric, such as earnings, sales, cash flow, or book value. Finally, you need to calculate the value of the asset by multiplying its metric by the average or median multiple of the comparable assets.

3 Advantages and disadvantages

DCF and relative valuation have advantages and disadvantages, depending on the context and purpose of the valuation. DCF is based on the intrinsic value of the asset, which reflects its future cash-generating potential and risk. It is also flexible and adaptable to different scenarios and assumptions. However, it is sensitive to the accuracy and reliability of the cash flow projections and the discount rate, which can be difficult to estimate and justify. Additionally, it can be complex and time-consuming to apply and interpret. On the other hand, relative valuation is based on the market value of the asset, which reflects the supply and demand of investors and prevailing market conditions. It is also simple and easy to apply and understand. Nevertheless, it is dependent on the availability and quality of comparable assets and multiples, which can vary widely and introduce biases and errors. Furthermore, it can be misleading and inconsistent if the comparable assets and multiples are not truly comparable or relevant.

4 How to choose

When it comes to valuing an asset, there is no one-size-fits-all answer. It depends on the type, nature, and characteristics of the asset, the availability and quality of data and information, the objective and perspective of the valuation, and the preferences and judgment of the analyst. However, some general guidelines to consider are using DCF to estimate intrinsic value based on cash flows and risk if reliable data is available; relative valuation to estimate market value based on performance and quality if a sufficient set of comparable assets is available; and using both methods to cross-check results and capture different perspectives.