Shortcomings of The NPV Approach To Valuing Stocks
November 22, 2013 Leave a comment
Shortcomings of The NPV Approach To Valuing Stocks
by csinvestingNovember 20, 2013
Part I: What are the three major shortcomings of using the Net Present Value Approach (“NPV”) to valuing companies?
The NPV approach has three fundamental shortcomings. First, it does not segregate reliable information from unreliable information when assessing the value of a project. A typical NPV model estimates net cash flows for several years into the future from the date at which the project is undertaken, incorporating the initial investment expenditures as negative cash flows. Five to ten years of cash flows are usually estimated explicitly. Cash flows beyond the last date are usually lumped together into something called a “terminal value.” A common method for calculating the terminal value is to derive the accounting earnings from the cash flows in the last explicitly estimated year and then to multiply those earning by a factor that represents an appropriate ratio of value to earnings (i.e., a P/E ratio). If the accounting earnings are estimated to be $12 million and the appropriate factor is a P/E ratio of 15 to 1, then the terminal value is $180 million. Read more of this post












