Discounted cash flow forecasts are absolutely the right way to value a stock in theory. But as my favorite business school professor told me, "In theory a giraffe shouldn't be able to walk, but it does."
I was an investment banker for four years, and spent many an allnighter creating ever more elaborate DCF models. Now that I am actually buying these companies, though, I consider that analysis an absolute waste of time because it is so sensitive to the slightest change in inputs. I have no delusions that I can forecast most of the businesses I own for two years, let alone 20. That is what Graham teaches me - when you buy at a low enough price, it doesn't matter if you're off by 20%, you still make a lot of money.
That said, though, free cash flow is the most critical concept in investing. Wall Street is obsessed with EPS and quarterly earnings forecasts, which I just consider silly. But really, that is all anybody talks about.
1. You can doctor earnings, but you can't fake free cash flow
2. You can't spend earnings
Take a look at Sunbeam's financials for the last three years. The company had an earnings turnaround, but free cash flow stayed negative. It should have surprised nobody when the story fell apart.
Jim
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