Just as we need to be cautious when using accounting information,

here's a word of warning when you're using discounted cash flow analysis.

And this is true for absolute valuation methods as much as it is true for

the relative valuation methods, the multiples that we discussed earlier.

Valuation models assume that markets are often inefficient.

For some reason, they get it wrong.

They don't get the right price for the cash flow entitlement.

But, eventually these markets come to their senses, and

the market value would equate to what we could label as, the true value.

Well that's a big call.

Keep in mind, that first and

foremost, financial analysts have got conflicting interests.

So, financial analysts' valuations are inevitably biased,

either in the sign of their valuation, whether it's a positive or

a negative net present value, or the size of the net present value forecast.

Sign and size of the bias will depend on the type of analyst.

And with that, we refer to sell-side analysts versus buy-side analysts.

Those analysts that work for someone who is buying will want to put a lower value

on the analysis, whereas those analysts that work for

people that are selling will want to inflate the price.

So be careful with analyst valuations.

And also not unimportantly, keep in mind that the more complicated valuation models

are not necessarily more accurate.

Keep it simple is the simple guidance here.

It's an art, not a science.

So, let's just recap the discounted cash flow valuation principles.

What does DCF really stand for?

We know that firm or project value as we discussed it today is the present

value of the firm or projects expected future cash flows.

That fundamental principle of valuation assumes that the firm or

the project has something which we could label as intrinsic or real value,

based on its current cash flows, and the growth in those current cash flows,

and risk of those current cash flows evolving in the future.

What the analyst does is the following.

The analyst for DCF needs to estimate the effective life of the project or the firm,

choosing n, the expected cash flows and then properly timed

over the effective life of the cash flow of the project or the firm.

And lastly the analyst needs to find the right discount rate,

get a good assessment on expected inflation, on the risks embedded in

the project, and on the opportunity costs, debt seems to be a big ask.

The inputs are all important in the accuracy of the evaluation.

So, here's a few good things about discounted cash flow analysis.

It's forward looking, and we do know that when we make a decision to

invest in a project or in buying shares in the firm

that we are really only interested in what is going to happen next.

We are interested in the future.

So that means that DCF is better aligned with wealth creation.