DCF = Discounted Cash Flows. It’s a shorthand way of saying that the current price of a share of stock in a given company should be the sum of the value in today’s money of all future all expected (let’s say, annually) cash flows, divided by the number of shares outstanding.
The big plusses of this approach are that:
–it’s simple
–it focuses on money, arguably the essence of all investing, so you don’t have to be an expert on any given industry, or in microeconomics in general,
–it applies to all companies,
–it’s similar to the way bond values are determined, and
–it allows quick computer-driven evaluation of large numbers of companies.
There are significant minuses, though:
–the present values can get very high, relatively quickly. The first practitioners quickly realized that that they could not allow substantial growth in cash flow to continue in their models for more than, say, ten years (I’m making this number up, but it’s something like that) or else everything would become deeply undervalued, and a foaming-at-the-mouth buy. The “one decision” stocks of the Nifty Fifty in the early 1970s (which included gems like Simplicity Pattern, Eastman Kodak, SS Kresge, Xerox and Schlitz Brewing) are perhaps the prime example of this phenomenon. The NF traded at around 100x current earnings on the idea they would grow forever. Whoops.
–the standard solution has come to be to allow a short period of super growth, then fade that back to GDP-like for another period, and project essentially no growth after that. …sort of like securities analysis, without the analysis. The issue here is that the NF also contained gems like Coca Cola and Walmart that received the same treatment.
–even the most sophisticated users of DCF have found that while, with well-crafted input, the calculations were able to identify areas of significant undervaluation, it might take half a decade (or more) for them to disappear. So unless a manage had extraordinarily patient clients, DCFs weren’t useful.
–as I see it, there’s a very small group of excellent securities analysts and a very large group of wannabes who are not so great at forecasting earnings. So getting good data to run DCF models is a major issue.
–stuff happens. For example, two things did Xerox in: cheaper, better copiers from Japan; and although its Palo Alto Research Center essentially invented the PC, top management opted to concentrate on real estate limited partnerships instead.