Discounted Cash Flow (DCF) vs. Target Price: Which is Better for Evaluating Stocks

The valuation process is crucial for making financial decisions regarding a company. By evaluating various variables and methods, it is possible to estimate a company's fair value and thus determine its investment potential or assess its market price. In this text, we will present the main types of valuations used by investors, financial analysts, and business managers, highlighting their specificities and advantages for decision-making.

There are several types of valuations that can be used to estimate a company's fair value. Some of the most common types include:
Multiples Valuation: This type of valuation compares the company in question with other companies in the same sector, using multiples such as price/earnings ratio, price/book value ratio, price/sales ratio, among others.
Discounted Cash Flow (DCF): This type of valuation projects the company's future free cash flows and then discounts these cash flows to present value using an appropriate discount rate.

Asset-based Valuation: In this type of valuation, the net value of the company's assets is calculated by subtracting total liabilities. The result is the company's net worth.
Real Options Valuation: This type of valuation applies real options theory to estimate the company's value, considering real options such as the right to defer an investment project or the right to abandon a project.
Comparable Transactions Analysis (CAT): This type of valuation uses recent transaction values of similar companies to assess the fair value of the company in question.

Economic Indicators Valuation: In this type of valuation, macroeconomic indicators such as inflation, interest rates, exchange rates, among others, are used to assess the company's value.
Venture Capital Valuation: This type of valuation is mainly used for startups and early-stage companies and is based on valuations made by venture capital firms investing in these businesses.

Thus, Valuation is a technique that allows evaluating the value of a company or asset, generally with the goal of making investment decisions. Considering the previously mentioned approaches to valuation, we have two of the most common ones, which are the Discounted Cash Flow and the Target (NYSE:TGT) (NYSE:TGT) Price, to find an intrinsic value in the price of a security. Now, let's discuss the pros and cons of each of these main approaches.

Discounted Cash Flow (DCF): The discounted cash flow is a valuation approach that uses the projection of the company's future cash flows and discounts these cash flows to the present value using a discount rate that represents the company's cost of capital. The idea behind DCF is that the value of the company is equal to the present value of its future cash flows.

Pros: DCF is an approach that explicitly considers the company's future cash flows, which can help understand the company's value generation. The use of a discount rate that represents the company's cost of capital can lead to a more accurate valuation of the company, as it considers the minimum return required by investors.

Cons: DCF depends on various assumptions, such as projections of future cash flows and the discount rate used. These assumptions can be challenging to make, especially in an uncertain business environment. DCF can be affected by small variations in the assumptions used, leading to a significant variation in the company's value.

Target Price: The target price is a valuation approach that uses a specific multiple to evaluate the company. This multiple can be based on various factors, such as the price/earnings (P/E) ratio or the enterprise value/EBITDA (EV/EBITDA) ratio. The idea behind the target price is that the value of the company is equal to this multiple times a specific financial metric. But let's delve further into the target price in different types of analysis.

Fundamental Analysis: This method involves analyzing the company's finances and fundamentals, such as revenue, profit, cash flow, debt, growth, and future prospects. Based on this data, you can estimate the company's intrinsic value and then calculate the fair stock price. For example, if the company has a projected free cash flow of $100 million for the next year, a projected growth of 10%, and a P/E multiple of 15x, the fair stock price would be calculated as 100 * (1 + 10%) * 15 = $1,650. This would be the target price for the stock.

Technical Analysis: This method involves analyzing price charts and technical indicators to identify price patterns and future trends. This may include analyses of support and resistance levels, moving averages, oscillators, candlestick patterns, among others. Based on these analyses, you can make a prediction about the stock price's future movement. For example, if a stock is in an uptrend, and the price is approaching a significant resistance line, a technical trader may calculate a target price based on the expectation that the price will break that resistance and rise further.

Comparative Analysis: This method involves comparing the company with other companies in the same sector or with similar companies in terms of size, growth, and other factors. Based on this comparison, you can calculate a valuation multiple (such as P/E or EV/EBITDA) and apply it to the company in question to get a target price. For example, if comparable companies have an average P/E multiple of 20x and the company in question has projected earnings of $100 million, the target price would be calculated as 100 * 20 = $2,000.

It is essential to remember that determining the target price of a stock involves many variables and uncertainties, and it is impossible to predict the future with certainty. Therefore, the target price should be seen as an estimate based on available information at the moment, and not a guarantee that the stock price will reach that value.

Pros: The target price may be easier to calculate than DCF since it depends on a single multiple and a single financial metric. The target price can be useful for evaluating the company in relation to other companies in the same sector or similar companies in terms of size, growth, and other factors.
Cons: The target price can be influenced by external factors, such as stock market behavior or variations in the multiple used. The target price may not take into account the company's long-term value generation, as it focuses only on a specific financial metric.

In conclusion, there is no perfect valuation approach, and each approach has its pros and cons. DCF can be helpful in understanding the company's long-term value generation, but it depends on challenging assumptions. The target price may be easier to calculate but can be influenced by external factors and may not consider the company's long-term value generation.

Ultimately, the choice of valuation approach will depend on the investor's objectives, the sector and the company in question, and the availability and quality of data. It is important to remember that the valuation of a company is just one part of the investment decision-making process, and other factors, such as management quality, market position, and the company's future prospects, should also be considered.