Sunday 27 March 2011

Valuing an asset using DCF and PER

Value investing is theoretically simple: buy assets for less than they're worth and sell when they approach or move beyond fair value. 


What 2 methods do you use to value assets?


1)  DCF


So too are valuing assets:discount future cash flows back to today at an appropriate interest rate for the life of the asset. The discounted cash flow (DCF) model is a commonly-used tool, hammered into every finance and business student.

But DCF models quickly deteriorate when they meet a rapidly changing world. The fact that most analysts failed to consider the impact of falling US house prices on their models played a major role in triggering the global financial crisis. Worse still, the misleading precision imbues investors with unwarranted overconfidence. Too often, models are precisely wrong.





2)  Price Earnings Ratio

Other tools are available to help you avoid this error. The price-to-earnings ratio (PER) is a regularly used proxy for stock valuation but also one of the most overused and abused metrics. To make use of it you need to know when to use it and when not to.


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