contrarianinthesensethatitforcesanalyststolookforthe
fundamentals that drive value rather than what market
perceptions are. Consequently, if stock prices rise
disproportionately relative to the underlying earnings and
cash flows, DCF models are likely to find stocks to be
overvalued,andiftheyfalldisproportionately,DCFmodels
find stocks to be undervalued.
Thereare,however,limitations withDCF valuation.Inthe
handsofsloppyanalysts,DCFvaluationscanbemanipulated
to generateestimatesof value thathaveno relationshipto
intrinsicvalue.Wealsoneedsubstantiallymoreinformation
to value a company with DCF models, since we have to
estimatecashflows,growthrates,anddiscountrates.Finally,
DCFmodelsmayvery wellfind everystockin asectoror
evenamarket tobeovervalued ifmarketperceptions have
runaheadoffundamentals.Forportfoliomanagersandequity
researchanalysts, whoarerequiredto find equities to buy
even in the most overvalued markets, this creates a
conundrum. They can go with their DCF valuations and
concludethateverythingisovervalued,whichmayputthem
outofbusiness,ortheycanfindanalternateapproachthatis
more sensitive to market moods. It should come as no
surprise that many choose the latter course.
Relative Valuation
While the focus in classrooms and academic discussions
remainsonDCFvaluation,therealityisthatmostassetsare
valuedonarelativebasis.Inrelativevaluation,wevaluean
assetbylookingathowthemarketpricessimilarassets.Thus,
whendeterminingwhattopayforahouse,welookatwhat
similarhousesintheneighborhoodsoldforratherthandoing