NPV valuation is unreliable
According to Henry Blodget, no investing advice seems more sound than that you should buy stocks when they are "cheap" and sell when they are "expensive." Wall Street, the financial press, and millions of investors devote countless hours and dollars to unearthing "undervalued" opportunities and panning "overvalued" ones. Business school professors forever develop and teach ever-more-refined valuation techniques. Fanatically precise analysts compute projected earnings to the penny and "intrinsic value" to the dollar.
But when are stocks cheap?
A share of stock is, in theory, worth the "present value of future cash flows" attributable to the share. Given the confidence with which some commentators cite the theory, a casual observer might assume that the "present value of future cash flows" is an indisputable number, akin to a price tag on a can of soup. In reality, however, it is not a number but an argument, and, in most cases, it is a surprisingly imprecise argument, with a wide range of reasonable conclusions.
An analysis of the "present value of future cash flows" requires, at minimum, two components:
1) an estimate of the future cash flows; and
2) an appropriate discount rate with which to determine their present value.
1. No one really knows what the future cash flows will be; and
2. Discount rates and terminal multiples are subjective assessments based on the trading prices and outlook for other securities (and, consequently, change as the prices of the securities change).
As a result, most valuation conclusions are extraordinarily subjective, and small tweaks in assumptions can yield big changes in estimated value. Rest of article