DCF model – Does it help?
Recently I read “Investment banking: Valuation, Leveraged Buyouts and Mergers & Acquisitions” by Rosenbaum/Pearl which inspired me to write an article explaining the theory of Discounting Cash Flow.
Discounted Cash Flow analysis (DCF) is one of the valuation tools that help to make a proper due diligence of a company. It has a widespread application in investment banking; corporate finance and it also might help individual investors to make a rational investment decision. Joshua Rosenbaum and Joshua Pearl stated that “the value of a company, division, business, or collection of assets can be derived from the present value of the free cash flow.” (FCF)
Now let’s talk a bit about free cash flow. It is the cash that was left after the paying all the operating and administrative expenses and also the taxes. Obtained FCF will be discounted by the discount rate called Weighted Average Cost of Capital (WACC). The projection period maybe 5 years or more as it depends on the industry. For instance, for defensive industries like food, tobacco, utilities the period maybe extended to 10 years .In addition, terminal value of a company is calculated in order to get the value of the target after the projection period. The sum of the discounted free cash flow and terminal value give the enterprise value of the company.
Basically, the correct valuation of the company depends highly on the discount rate. For large caps the rate is around 11%, for small caps the rate should be more than 11% because they are considered more volatile and for blue chips it is possible to discount at 10%. And here come some tricks. In my opinion, the discount rate cannot stay the same for the whole projection period. Of course, bankers perform sensitivity analysis for best case and worst case scenarios regarding sales and discount rates, but in this case it puts the model highly dependable on the assumptions. For instance, in 3rd year of operation a company might increase leverage and exceed the optimal leverage level, thus increasing the discount rate.
How can we predict facebook sales in the next 5 years? We live in a very globalized and interconnected business environment that may question such models even more in the future. Now let’s think about the business failures from the past like Enron (utility company) and Parmalat (Food Company). Both theoretically were considered defensive because putting it simple people need energy, people need milk and other dairy products. Was it possible to calculate correctly the discount rate, terminal value, sales projections for those companies for 5 year projection period? The answer is obvious- No! Of course those two and some other companies like Lehman Brothers might be considered as outliers, however they hurt hundred thousands of employees and investors who were dependant on the “cash flows” of those companies.
To sum up, some shortcomings of this valuation model might cause big problems for businessmen and investors which rely on the output produced by the model. I am looking forward for your comments and criticism regarding my first blog entry.
Amen brother. I echo your sentiments entirely. Detailed reply coming this evening.
That's why the DCF model isn't so prevalent on the buy side.
I don't understand the point of your "article". You start by describing how to do a DCF and finish with an awkward criticism regarding its effectiveness.
While a DCF has its shortcomings, the inability of a DCF to "predict" that companies like Enron and Parmalat were going to shit has little to do with the methodology itself. These companies were cooking their books which is obviously illegal since it distorts the information you have at hand to make a proper assessment of the companies' operations. Without a fair glance at a company's cash flows, then it's impossible to perform a sound DCF and determine the intrinsic worth of the company. But had investors and analysts been afforded with "clean" financial statements (or perhaps looked more closely at those 10-Ks), then I do think you can reasonably estimate sales growth and discount rates.
Not sure about other firms or "buyside" industries, but at least where I work at doing a DCF is pretty normal. Ultimately - as we all know - valuations are as much of an art as a science. So the assumptions we use are what ultimately determine the output of a DCF - otherwise, there would be no need for analysts and associates (as mindless as our jobs seem at times). But given how assumption-laden a DCF is, the methodology should always be counterbalanced by other techniques, be it relative market valuations or asset-centric valuations.
The point of the article was to analyse DCF from different perspectives. I do not say that the model is good or bad, I have just tried to illustrate some disadvantages of it. I agree that it is an art rather than science. The point is that even if you understand the industry perfectly, it is impossible in my opnion to predict precisely the future cash flows for the next 5-7 years. Moreover, there are some companies where it is extremely difficult to select comparables and on the basis of comparables to make reasonable sales projections. That was one of the points of the article. I am not an industry professional yet.Thanks for your comments anyway.
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