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Why is Discounted Cash Flow (DCF) Method not suitable for valuing stock options?
The Discounted Cash Flow (DCF) method is a widely used technique for valuation in the financial world. The extended procedure of Net Present Value (NPV) is an exclusively used technique in valuing capital investment projects. These projects usually cover the purchase of machinery and equipment as well as the valuation of businesses in cases of mergers and acquisitions (M&A).
The DCF method may be quite popular, but it has a major flaw: it does not show any flexibility of cash flows. In the real world, capital investment projects can be changed at any time, and hence, the DCF technique is worthless as it cannot adapt to the changing circumstances. In other words, the DCF technique cannot be applied to the stock options strategies because it does not consider the real-time changes occurring in business environments.
Here are some examples where the DCF technique is not so useful −
Example 1
Suppose you want to change all the equipment of your company and you want to check whether the project will be successful by installing one or two machines. Here, you keep the right to cancel out the plan if things don’t work out as planned. In fact, it makes some sense too. Why should you buy or install machinery that doesn’t fit your business?
This can be compared with a call option. You have the right to buy the options with a strike price, but you are not obligated to buy them within a deadline.
Example 2
Let’s check out another example.
Suppose you are experimenting with a project that will have some future cash flows. There are some uncertainties if the project will work as planned because the cash flow is not guaranteed. Therefore, you might want to use a method of valuation that can consider this sudden and unguaranteed situation.
This can be considered with a put option where you can sell an option, but you are not obligated to do so within a deadline.
Conclusion
In the above examples, we have dealt with day-to-day examples of options. It has been found that the DCF technique is incapable of flexibly dealing with the options, as there is no way to calculate the flexible cash flows that may occur at any time.
The discounted cash flow mechanism assumes that you will stick to a given deadline and you are obligated to do so until the maturity or deadline is reached.
The DCF model however has certain advantages too, but for that, the deadline and pricing mechanism have to be perfect. That is why the DCF technique is not suitable for valuing options.
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