Saturday, May 27, 2017

DCF Analysis and the Allocation of Capital

            Much of this blog has focused on fundamental valuation as an investment tool that can be used to identify mispriced stocks and, hopefully, make superior returns.  While important to individual investors, there is another aspect of fundamental valuation that is more important from a social perspective.  Remember that in a market economy the social function of the financial market is capital allocation.  There is no central planner to decide how much money should be allocated to social media, versus electricity transmission, versus automobile manufacturing as so on times thousands. 

            To see how DCF analysis plays a central role in the allocation of capital imagine a thought experiment in which a fresh $1 million is injected into the capital market.  Where does it get allocated in a competitive market?  The answer is to that activity which investors conclude has a present value of expected future cash flows most in excess of $1 million.  That is to the activity that has the greatest DCF value.  So DCF analysis is not just a tool for making money.  It is a critical part of the process by which society decides what things are worth doing.

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