How to improve your Discounted Cashflows Valuation when you value a Business
The Discounted Cashflows Method ("DCF") is very commonly used in business valuation and valuation for financial reporting. We share with you the most common issues faced in a DCF valuation and how to resolve them.
What is the Discounted Cashflows Valuation Method
The Discounted Cash Flow (DCF) valuation method is a fundamental approach used in finance to value a business, an investment, or any cash-generating asset. It calculates the present value of the expected future cash flows of the asset. The idea behind DCF is that money received in the future is worth less than money received today, and this method adjusts for that time value of money.
The DCF valuation method is a very commonly used valuation method to value businesses which are going-concern. The DCF method is an income method of valuation and there are many variants of the DCF used to value intangible assets as well. DCF variants include the Multi-period excess earnings method, Greenfield Method, With-and-without methods.
A typical DCF framework is:
Forecast Future Cash Flows: Estimate the cash flows the asset will produce in the future. This could be on a yearly, quarterly, or monthly basis. For businesses, this is typically based on earnings before interest, taxes, depreciation, and amortization (EBITDA), but can also be net income, free cash flow, or other measures. The forecasting period is typically between 5 to 10 years, but it can vary based on the asset or investment.
Determine a Discount Rate: This is the rate at which future cash flows will be discounted to give them a present value. It's a reflection of the risk associated with the asset or investment. The riskier the investment, the higher the discount rate. Commonly, the Weighted Average Cost of Capital (WACC) is used for businesses.
Calculate Present Value of Cash Flows: Each of the future cash flows is discounted back to the present using the discount rate. This gives you the present value of each future cash flow.
Calculate Total Present Value: Sum the present values of the forecasted cash flows and the terminal value. This gives you the total present value of all expected future cash flows.
Subtract Liabilities (if valuing a business): If you're valuing a business, subtract its liabilities (like debt) from the total present value to get the equity value.
The Foundation of a Good DCF Valuation when valuing a Business
The Discounted Cash Flow (DCF) model aims to determine the intrinsic value of an asset or business based on its expected future cash flows. The foundation of a good DCF valuation is:
Economically Sound: The projections for a company's return and growth should be consistent with its market position and historical data. For example, expecting a mature company in a saturated market to grow at the same rate as a start-up in a nascent industry would be economically unsound. Also, over long periods, high growth rates and extraordinary returns tend to revert to industry averages.
Transparent: All assumptions and methods used in the DCF model should be clear, understandable, and justifiable. A transparent model allows stakeholders to easily scrutinize and challenge assumptions, leading to a more robust valuation.
However, many DCF models fall short because of overly optimistic projections, misuse of terminal values, or unclear assumptions. It's crucial to approach DCF modeling with rigorous attention to detail, grounded economic reasoning, and a commitment to clarity and transparency.
Common Errors in DCF Valuation Models when valuing Businesses
1) Forecast period is too short - The DCF method of valuation implies that the historical revenue and earnings profile cannot be applied to the future. Hence, we need a set of forecasts to reflect the expected changes to the business.
Using a short-term cashflows forecasts (we define short term as less than three years) contradicts the principle that asset prices reflect long-term cashflows. Having too short a forecast means the investors have to compensate for a disproportionately large terminal value.
We prefer to have a forecast of at least five years. Longer forecasts may be justified for example in certain industries such as utilities where customer/government contracts are much longer.
Ideally the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance.
2) Unresonable long-term growth rates - In a competitive market, the return on investment will approximate the cost of capital over time.
We frequently observe modellers apply an EBITDA multiple to the terminal year to calculate the terminal value. A 13x EBITDA multiple could imply a 6 percent earnings growth and 150 percent return on incremental capital forever. This incredible rate of return forever clearly does not happen in the real world.
Therefore, phasing the model into a period of value creation and value neutrality makes more economic sense. We then capture the continuing value with a perpetuity assumption. This assumption implies a reversion-to-the-mean principle.
3) Mismatch between assumed investment and earnings growth - DCF models often understate the investment necessary to achieve an assumed growth rate. Return on investment ("ROI") determines how efficiently a company translates its investments into earnings growth. Theoretically, ROI tend to the cost of capital over time.
Modellers should link growth and investments via ROI. This can be an explicit output in the financial model. If the changes in ROI cannot be explained thoughtully based on the strategic plan of the business, it is likely that the financial model is not reliable.
4) Incomplete accounting for other liabilities - Most modellers do a good job of capturing debt and lease liabilities in the forecasts. However, there are other liabilities that need to be accounted for in the cashflows. If not, the cashflows could be signficantly understated.
For example, such other liabilities include post-retirement employee benefit plans and employee stock options.
5) Cost of Capital - The cost of capital used should reflect the risk of the expected cashflows. The risk of the expected cashflows come from many sources including the country of business operations, FX and specific risks related to the company.
We often see a mismatch where the cost of capital doesnt capture all the necessary risks in a systematic way.
For investments in developing countries where capital markets are not developed. We recommend that we start the CoC calculation using a mature market as a reference point. We then account for risk components such as country risk, small company risk and company specific risks. If the underlying cashflows of the company is a local currency, we should convert the USD-cost of capital to a locay currency cost of capital using either the Fischer equation or the interest rate parity formula.
6) Scenario Analysis - Many DCF models use sensitivity analysis based on factors like cost of capital or growth, but these often don't give a clear insight into the business's true prospects. Instead, investors should focus on value drivers such as sales, margins, and investment needs. Standard sensitivity analysis might miss the interconnectedness of these value drivers. For a more accurate valuation, scenario analysis should examine how changes in one value driver can impact others.
Conclusion on how to improve your DCF valuation for business valuation
We have highlighted the common issues which we have encountered in the DCF valuation. Although valuation is both art and science, we still need a strong theorectical framework when doing a DCF valuation. We hope that readers find this article useful when doing their next DCF valuation.