Why DCF model does not include book value?

Discussion in 'Trading' started by qll, Jun 23, 2007.

  1. qll


    DCF is only calculationg future cash flows, but does not include the company's current book value. For example a company using DCF model, can be valuated at $20, but its book is $10. Its current price is $22. I would say it is under valued $22 < $20+$10, but DCF would say it is overvalued $22 > $20.
  2. Look up "sunk cost fallacy", that should help you on your way.
  3. "A common example of a sunk cost for a business is the promotion of a brand name. This type of marketing incurs costs that cannot normally be recovered."

    Question Pointone,

    Trump selling water (Trump Ice) is a concept to promote his brand and avoid a sunk cost. It is not about making a profit or being in the water business but only to self promote his brand which is his name and what he is known for and that is real estate.

    He would still have value at the end of his water promotion (ie, sales are poor) and some recovery of whatever assets he invested in the water business. This would be opposed to just taking out a full page ad or tv commercial with his name on it to keep it out front, which would be a sunk cost.

  4. qll


    i don't see the relation to DCF and stock valuation.
  5. If you use DCF method, the assumption is that the business is a going-concern entity and that it will not be liquidated. Therefore, combining it with book-value or with market value of the assets owned is of contradiction.

    If the entity is expected to continue to operate, then use DCF.

    If the entity is expected to file for bankruptcy or that it is in some kind of real-estate business, then use the market value of the equity.

    If you know the business will operate for a certain number of periods and then be liquidated, then combine the DCF and the market value of the equity.

    Never use book value (unless you are valuating bonds)

    I hope this helps!

  6. qll


    thanks. i understand your point, becuase in your calculation, the biz goes forever. however, i found the stock price is mainly valuated at its current year, past year, next year P/E. for example, if a company earns 80c 100c expect 120c. its reseaonble valuation could be 16 20 24. but if it has a bookvalue of 10, it reduced downward risk greatly, so instead of dropping from 16 to 0, it can only drop from 16 to 10. so its expected return will be much greater, thus, more capital will be invested and priced will be pushed higher.

    i have been using a combo of bookvalue+P/E (not even DCF, but i look for questionable investment that turn earning into negative CF.). my mothod works much much better (because my prediction of future stock price is much closer to its real price 1-2 years later. if i use DCF, i will get lowered expectation.)
  7. One of the flaw I see in valuation with book value is that it does not reflect the market value of those assets that belong to equity. It could be higher or it could be lower. Using market value would be much better, however it would be difficult to find the market value of every asset in the company.

    We maybe double counting if we add the book value to the the price arrived from DCF or P/E. However, we should not use the book value as lower limit indicator, because book value could change if the company is not doing well. For example, if a company is incurring losses each year and the losses are cutting into the retained earnings, book value would then deteriorate. All of a sudden, our lower limit will no longer be correct.

    However, if the company has decided to discontinue its operation, then and only then liquidation value (notice that I am not mentioning book value) could be used.

    I hope this helps too.

  8. I know!

    The link is that book value is calculated on an historic cost basis (the costs sunk into the business). It is irrelevant to the future cash flows (which ultimately determine the value of the business).

    Book value can be manipulated, for example by changing your depreciation policy from 20 years to 1 year or loading the balance sheet with debt. This has little or no bearing on the value of the enterprise as a going concern but would radically alter the reported book value.

    In some businesses the business value may bear close correlation to the book value (e.g. banks) but you should still look at the cash flow generating potential of the assets over their lifetime. P/E does this too in a summary fashion - most people just don't realise the link between P/E and DCF (and yield and discount rate).

    In the end, all assets are valued such that their current yield comes into line with other assets of equivalent risk and maturity.