Found this great article from Michael Mauboussin, Chief Investment Strategist of Legg Mason Capital Management (LMCM). It is a 12 page article on the common errors investors commit in using the DCF (Discounted cash flow) model.
Personally my approach to valuation (which is not original and mainly developed from reading) is to create a DCF model for three scenarios. I extend the current business condition and create an as-is scenario. So the assumption is that the current growth rates, margins, competitive situation etc will continue as is. The second scenario is an optimistic scenario where in I try to calculate the intrinsic value using the most optimisitic assumptions for growth rates, margins, competitive intensity etc. The third scenario is the pessimistic scenario with poor growth rates, high competitive intensity etc.
I try to associate probability against each scenario and try to calculate the expected value.
So expected value is = intrinsic value (as is) * probability for ‘as is’ + instrinsic value (optimistic scenario)* probability for optimisitic scenario + intrinsic value (pesimistic scenario) * probability for pessimistic scenario.
I also cross check the above expected value with ratio based valuations.
The above approach forces me to think harder on all my assumptions. Also when the annual results are declared for any company I have invested in, I go back to my excel spreadsheet and relook at the numbers, assumptions etc and calculate the new intrinsic value again. This gives me an idea on whether I should sell, buy more or hold.
I am not able to post my valuation / analysis spreadsheet on the blog. If any one is interested, please e-mail me on email@example.com