DCF - A way to check your value
Members,
When you are modeling using DCF, is there a general rule of thumb that you can use to tell whether your value makes sense or not?
Thank you!
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Compare it to other valuation methods. See what you get using multiples or precedent transactions.
Check how much weight your terminal value has in your valuation - if it's >50% that's a red flag and warrants double checking your assumptions. Make a sensitivity table to see how much your valuation changes as the discount rate and terminal multiple are altered slightly. No hard rules though.
I think 50% is a bit low (unless you have a high WACC or low multiple). Assume you have 5x (not large by any means) terminal multiple with 5 yr projections beforehand you'll be close to 50:50 (ignoring discounting), so you're saying that multiples above 6x (starting to factor in discounting) are spurious. and that's ignoring the fact that the terminal value will be a multiple of a larger EBITDA in year 5 (lets assume some growth), which will exacerbate the issue.
I don't know if I should say something this obvious, but if it's a publicly-traded company, compare against the market value. If the market cap has too many/few 0's, you're probably wrong.
Damodaran on his videos mentioned checking how feasible the growth rate is, e.g. you can't have 110% of market share, growth shouldn't be a lot higher than reinvestment rate * return on capital (unless you also expect improvements in roc), projecting that over time company becomes more mature (lower WACC with possibly more prudent capital structure) and loses its competitive advantage, hence the excess return (ROC - WACC) gets smaller
M&A - high enough to flatter the CEO but not so high that it looks unrealistic or that the sale doesn't go thru when the incoming bids inevitably disappoint and steadily decrease over the course of due diligence. Easy way to gauge this: did the MD make you go back to your desk and redo it?
Restructuring (creditor advisor) - high enough to deliver 100% of the newco equity to your constituents, but not so high that any junior creditor/equity holder gets any newco equity - cushion on either side to be safe
Restructuring (debtor advisor) - low enough so that management can beat the projections without even getting out of bed and rake in massive incentive plan bonuses
DM&A - whatever gets that shit out the door ASAP
Liquidation - same as above, but on xlax
In seriousness I agree with most of the advice above. DCF probably should be a bit less than transactions (because transactions tend to be inflated as a result of transaction premiums/stupid deals/empire building/the fact that the current market is totally different than when big transactions probably happened) but then DCF is the only method that treats the company as unique and acknowledges its relative strengths.
If you come to a higher value in DCF there should be some rationale as to why on a relative basis that company should be more valuable than its peers - could be some product position advantage, higher growth end markets, etc. - but generally if you are within 1-2 turns of EBITDA to your other approaches it wouldn't look too crazy. 3 turns would look a bit too much to me but that's just my perspective.
Thanks everyone.
Quick DCF question: can it ever be negative? (I assume the answer is no?) If it is negative then do you ignore it and use the other methods?
What happens when there are no similar precedent transactions (assume a completely new innovation came about and they started their own business) and there are no good 'comparables'. What else can you do?
can be -ve, your PV of your projected losses would have to be > than the PV of your terminal value. and if your terminal value is -ve, walk away, don't bother doing any more work
revenue multiples. if no comps, it's not a bankable business and should be left to the public sector or VC guys who are willing to take a punt.
I find DCF's to be comedic... you might as well just pick a number and build the dcf backward from there.
Right so how much value does the whole DCF exercise add? We usually do one from scratch with reasonable assumptions then start finagling it to where we want it. My point is that it's a largely useless valuation method.
DCF Review / Help? (Originally Posted: 11/19/2015)
Hello everyone,
I'm in need of some help with DCF modelling, as it is my first time working with the model. I've attached the work I've done on Harmon International Industries (this is just for practice, and I chose a company that are in line with my interests). If anyone can go over it and give me some feedback, I would greatly appreciate it.
My main concern is that I am getting two very different share values from the Perpetual Growth method and Exit Multiple method. Should these two approaches return similar numbers? Or are there cases where they can be a little different?
I'm asking for general feedback and suggestions to improve the model and correct any errors I may have made (I'm sure mistakes were made).
One quick question: what method is most commonly used to determine an appropriate rate for expected market return?
Thanks in advance.
Thanks Oreos! :)
I'd guess there's a misalignment between the ending multiple of 12.15 and a long term growth rate of 10%. I wouldn't just assume their current multiple is what is justified in perpetuity.
Some slides from Damodaran on how to justify an EV/EBITDA multiple. If link doesn't work just google "implied growth rate in ebitda multiple" and should be first entry.
http://people.stern.nyu.edu/adamodar/pdfiles/vebitda.pdf
What do you mean? Should those two values be the same?
A couple things.
First of all, in your data table, the row and column (exit multipes/perpetuity, and WACC) should NOT be linked to any other cell. For example, cell H64 should just be "10%" as a hard input. Linking it messes up the sensitivity. That's why, for example, a 12.15x multiple with a 13.7% WACC is giving you two different answers--on cell I54, you calculate that to imply an equity value of $89, yet in your table you get around a $78 implied share price instead. So manually enter all the WACC, exit multiple, and perpetuity growth rate values in those tables to fix that.
In terms of the variance in share prices, I would agree with the poster before me in terms of misalignment between the multiple and the perpetuity methods. Other than the mistake with the sensitivity tables (which does bring your values closer together) everything else checks out.
A multiple has an imbedded growth rate assumption in it.
So in your terminal growth rate example you figure out EV assuming a steady growth rate of FCFF. So EV = FCFF/(WACC - g). In slides I linked from Damodaran, he divides both sides by EBITDA to turn this into a multiple.
So EV/EBITDA = (FCFF/EBITDA)/(WACC -g)
So we can then breakdown FCFF = EBIT(1-T) + Depreciation(t) - Capex - change in WC
Then we get EV/EBITDA = (EBIT(1-T)/EBITDA)/(WACC -g) + (Dep(t)/EBITDA)/(WACC -g) - (Capex/EBITDA)/(WACC -g) Because you're in steady growth you just assume change in WC is zero. If you plug in your numbers assuming the 10% growth rate and solve for the EV/EBIDTA multiple you get something close to 15x. Which is why your DCF w/ terminal growth rate gives you a higher value than using a 12.15 terminal multiple.
You could also plug all your numbers into the formula, set the equation equal to a 12.15 multiple, and solve for g to see what growth rate is imbedded in a 12.15 EBITDA multiple.
Thank you for all the feedback guys! 1logic do you mean the implied growth rate using exit method (and implied exit multiple from the growth method)? This was a template and I notice now the implied multiple formula is incorrect.
I've read that the growth rate should be in line with the country's GDP (generally 3%-4%) and not exceed it. I tried using these numbers and my DCF outputted an implied share price that is 57% below current price. Using a growth rate of 10% gave me a much more realistic implied price. Is the growth rate dependent on the company or should it always be around GDP growth rates?
What growth rate are you talking about? Is it the growth rate leading to the terminal growth rate or the terminal growth rate itself? If it's the latter then in practice you'd never really see 10% suggested as a TGR. If you use 3-4% as your terminal rate (which may very well be too high as well depending on the regional exposure of the company), then it could be that your interim growth assumptions are wrong, or simply the discount that you're using is wrong. Remember: in a DCF, you have more than one lever to pull. Finally, even after playing around with all of these levers, it may well be the case that the company is indeed heavily overvalued.
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