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Tuesday, March 29, 2005

Using DCF Analysis (from the Motley Fool)

David Meier at The Motley Fool has a good article on using discounted cash flow analysis for valuing stocks. He does a very good job of explaining the mechanics of it. The best section in the article is when he starts discussing some of the pitfalls of using this method:

Pitfall No. 1: We don't know jack
I know that sounds harsh, but it's the truth. We cannot consistently predict the cash flows and their growth rates with any accuracy; the business environment is far too dynamic. Of course, we should try to make the best estimates we can. And that means being careful about our assumptions and predictions because we don't want to have the pitfalls of the equation work against us.
Click here for the whole article.

Most good students can grasp the mechanics of doing some type of valuation exercise (i.e an NPV calculation or an option-valuation problem) pretty easily. They just do a dozen or so problems and they're set. However, in most problems, the inputs (the cash flows, the discount rate, etc..) are given.

However, they real "money" (no pun intended) comes to those who can come up with the right inputs. Once that's done, there are always grunts who can crunch the numbers.

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