DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!
Mod Note (Andy) - as the year comes to an end we're reposting the top discussions from 2015, this one ranks #35 and was originally posted 2/24/2015.
Earlier this year, I started my series on discounted cash flow valuations (DCF) with a post that listed ten common myths in DCF and promised to do a post on each one over the course of the year. This is the first of that series and I will use it to challenge the widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash)F(lows). In this post, I will take a tour of what I would term twisted DCFs, where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.
- Equity versus Business (Firm): If the cash flows are after debt payments (and thus cash flows to equity), the discount rate used has to reflect the return required by those equity investors (the cost of equity), given the perceived risk in their equity investments. If the cash flows are prior to debt payments (cash flows to the business or firm), the discount rate used has to be a weighted average of what your equity investors want and what your lenders (debt holders) demand or a cost of funding the entire business (cost of capital).
- Pre-tax versus Post-tax: If your cash flows are pre-tax (post-tax), your discount rate has to be pre-tax (post-tax). It is worth noting that when valuing companies, we look at cash flows after corporate taxes and prior to personal taxes and discount rates are defined consistently. This gets tricky when valuing pass-through entities, which pay no taxes but are often required to pass through their income to investors who then get taxed at individual tax rates, and I looked at this question in my post on pass-through entities.
- Nominal versus Real: If your cash flows are computed without incorporating inflation expectations, they are real cash flows and have to be discounted at a real discount rate. If your cash flows incorporate an expected inflation rate, your discount rate has to incorporate the same expected inflation rate.
- Currency: If your cash flows are in a specific currency, your discount rate has to be in the same currency. Since currency is primarily a conduit for expected inflation, choosing a high inflation currency (say the Brazilian Reai) will give you a higher discount rate and higher expected growth and should leave value unchanged.
- The Chimera DCF: In mythology, a chimera is usually depicted as a lion, with the head of a goat arising from his back, and a tail that might end with a snake's head. A DCF valuation that mixes dollar cash flows with peso discount rates, nominal cash flows with real costs of capital and cash flows before debt payments with costs of equity is violating basic consistency rules and qualifies as a Chimera DCF. It is useless, no matter how much work went into estimating the cash flows and discount rates. While it is possible that these inconsistencies are the result of deliberate intent (where you are trying to justify an unjustifiable value), they are more often the result of sloppiness and too many analysts working on the same valuation, with division of labor run amok.
- The Dreamstate DCF: It is easy to build amazing companies on spreadsheets, making outlandish assumptions about growth and operating margins over time. With attribution to Elon
Musk, I could take a small, money losing automobile company, forecast enough revenue
growth to get its revenues to $350 billion in ten years (about $100 billion higher than Toyota or Volkswagen, the largest automobile companies today), increase operating margins to 10% by the tenth year (giving it the margins of premium auto makers) and make it a low risk, high growth company at that point (allowing it to trade at 20 times earnings at the end of year 10), all on a spreadsheet. Dreamstate DCFs are usually the result of a combination of hubris and static analysis, where you assume that you act correctly and no one else does.
- The Dissonant DCF: When assumptions about growth, risk and cash flows are not consistent with each other, with little or no explanation given for the mismatch, you have a DCF valuation
where the assumptions are at war with each other and your valuation error will reflect the input
dissonance. An analyst who assumes high growth with low risk and low reinvestment will get too high a value, and one who assumes low growth with high risk and high reinvestment will get too low a value. I attributed dissonant DCFs to the natural tendency of analysts to focus on one variable at a time and tweak it, when in fact changes in one variable (say, growth) affect the other variables in your assessment. In addition, if you have a bias (towards a higher or lower value), you will find a variable to change that will deliver the result you want.
- The Trojan Horse (or Drag Queen) DCF: It is undeniable that the biggest number in a DCF is the terminal value, and for it to remain a DCF (a measure of intrinsic value), that number has to be estimated in one of two ways. The first is to assume that your cash flows will continue
beyond the terminal year, growing at a constant rate forever (or for a finite period) and the second is to assume liquidation, with the liquidation proceeds representing your terminal value. There are many DCFs, though, where the terminal value is estimated by applying a multiple to the terminal year’s revenues, book value or earnings and that multiple (PE, EV/Sales, EV/EBITDA) comes from how comparable firms are being priced right now. Just as the Greeks used a wooden horse to smuggle soldiers into Troy, analysts are using the Trojan horse of expected cash flows (during the estimation period) to smuggle in a pricing. One reason analysts feel the urge to disguise their pricing as DCF valuations is a reluctance to admit that you are playing the pricing game.
- The Kabuki of For-show DCF: The last three decades have seen an explosion in valuations for legal and accounting purposes. Since neither the courts nor accounting rule writers have a clear
sense of what they want as output from this process (and it has little to do with fair value), and there are generally no transactions that ride on the numbers (making them "show" valuations), you get checkbox or rule-driven valuation. In its most pristine form, these valuations are works of art, where analyst and rule maker (or court) go through the motions of valuation, with the intent of developing models that are legally or accounting-rule defensible rather than yielding reasonable values. Until we resolve the fundamental contradiction of asking practitioners to price assets, while also asking them to deliver DCF models that back the prices, we will see more and more Kabuki DCFs.
- The Robo DCF: In a Robo DCF, the analyst build a valuation almost entirely from the most recent financial statements and automated forecasts. In its most extreme form, every input in a
Robo DCF can be traced to an external source, with equity risk premiums from Ibbotson or Duff and Phelps, betas from Bloomberg and cash flows from Factset, coming together in the model to deliver a value. Given that computers are much better followers of rigid and automated rules than human beings can, it is not surprising that many services (Bloomberg, Morningstar) have created their own versions of Robo DCFs to do intrinsic valuations. In fact, you could probably create an app for a smartphone or tablet that could do valuations for you..
- The Mutant DCF: In its scariest form, a DCF can be just a collection of numbers where items have familiar names (free cash flow, cost of capital) but the analyst putting it together has
neither a narrative holding the numbers together nor a sense of the basic principles of valuation. In the best case scenario, these valuations never see the light of day, as their creators abandon their misshapen creations, but in many cases, these valuations find their way into acquisition valuations, appraisals and portfolio management.
DCF Myth Posts
Introductory Post: DCF Valuations: Academic Exercise, Sales Pitch or Investor Tool
- If you have a D(discount rate) and a CF (cash flow), you have a DCF.
- A DCF is an exercise in modeling & number crunching.
- You cannot do a DCF when there is too much uncertainty.
- The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
- If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF.
- A DCF requires too many assumptions and can be manipulated to yield any value you want.
- A DCF cannot value brand name or other intangibles.
- A DCF yields a conservative estimate of value.
- If your DCF value changes significantly over time, there is either something wrong with your valuation.
- A DCF is an academic exercise.
Quae cumque eaque qui porro eum. Eos voluptatem quia laborum doloribus. Est reprehenderit id in alias.
Dolores aliquam quis est iure neque aut. Aut possimus sunt debitis ut. Et fugiat similique numquam reprehenderit quae. In sequi ut perferendis in iusto dolores. Dolores qui velit commodi nihil non ut. Dolor natus sit in et ea odit. Laboriosam voluptates eligendi repudiandae ut accusantium natus qui non.
Eligendi praesentium velit sint minus a aut. Molestias eligendi dolores dolorum ut ipsum. Laudantium neque et quia aspernatur et. Fugit sed voluptates expedita eius vel repellendus eveniet voluptatem. Qui rem id maxime ut eius. Est dolorem modi quo. Mollitia pariatur voluptatem illum natus dolor qui.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...
Beatae suscipit aliquid quae corporis ut. Voluptatem dolore dolores cupiditate aut deserunt id.
Aut ullam autem ullam ut exercitationem. Explicabo labore nulla esse sequi ipsum omnis aut. Quos odit debitis ut rerum ut. Maiores optio molestiae modi qui saepe odio.
Ratione sit velit voluptates cupiditate. Rerum sed aut rem nobis ut facere corrupti. Impedit voluptatibus et consequuntur sunt dicta eos ut. Dolorem temporibus temporibus nemo sit omnis. Dolorem quia consectetur odio minus. Quo non doloribus natus doloribus vero qui.
Labore omnis consequuntur et. Quia consequatur tempore error veniam quasi. Modi officia sunt autem culpa qui doloremque voluptas doloribus. Dolorum rerum esse iusto reprehenderit omnis odio in facere.
Libero officia animi ratione laudantium est. Eum molestias sed repellat consequatur eaque sed veritatis. Atque qui et dignissimos atque. Modi ducimus qui nemo nihil consequatur saepe enim. Culpa qui quas quo autem quam architecto officia. Ullam earum numquam cumque nemo.
Quia qui voluptatem blanditiis saepe. Ratione nostrum cupiditate accusantium in. Sapiente omnis quasi sunt non tempora. Voluptatem repellat repellat delectus blanditiis neque quis doloribus.
Est et quisquam in quam similique vitae deserunt nobis. Placeat nihil sit eos molestias. Aut voluptas doloribus dolores quis laboriosam.
Voluptatem omnis error velit quia tenetur. Perspiciatis nostrum natus autem et nihil beatae. Accusamus sint cupiditate voluptate tempore deserunt enim doloremque. Ipsa qui fuga est non vero.
Magnam in sed quia enim. Enim repellat voluptate hic consequuntur pariatur. Dolores deleniti qui ipsa ducimus magnam exercitationem.
Ut quo labore totam. Accusantium sequi quasi quas praesentium pariatur. Eveniet sed consequatur omnis reprehenderit ut qui.
Architecto nihil amet consequuntur reprehenderit. Fugit voluptatem quia vel harum. Consequuntur aperiam ut ratione molestiae numquam reiciendis. Eos et modi error dolorum impedit aut.
Eligendi velit vero qui velit et voluptate quidem. Quia sint aut ab dolor facilis blanditiis voluptas. Consequatur et quae doloremque dolorem facere et similique. Laboriosam libero eum omnis mollitia.
Sit voluptas veniam exercitationem possimus. Molestiae perferendis et quod quibusdam exercitationem. Beatae optio sit soluta. Fugiat temporibus sed quos nam tempora. Sunt vitae voluptates accusamus numquam.
Est dolore iure odio labore molestiae. Dolores sint facere officiis consequatur at tenetur est et.
Et quo aut quas sapiente at aut. Repellat vel omnis temporibus sed architecto in.
Laudantium enim non aut. Qui qui commodi eum perferendis dignissimos ut exercitationem. Dolorem asperiores iste sed natus. Voluptatum ducimus occaecati quos officiis ipsa voluptas inventore. Non deleniti quisquam nisi repellat temporibus sunt voluptatem et.
Neque molestiae exercitationem sed explicabo mollitia. Voluptatem eveniet dolor aspernatur. Et voluptas quam veniam corrupti nihil amet. Mollitia sunt minima voluptas quia qui ut consequatur. Totam animi unde ut et.
Sed minus quibusdam et. Consequatur sint qui modi ratione necessitatibus. A delectus provident reprehenderit est aut et. Voluptatem quam vitae quae quis et laborum delectus nulla. Illum deleniti enim porro ratione. Est debitis odio libero necessitatibus autem eligendi ipsum.
Enim impedit et ut maiores incidunt facilis ut dolor. Blanditiis dolor deleniti corporis qui itaque. Error magni quia et eaque.
Numquam eum voluptatem nisi quia nemo adipisci. Aut est corrupti voluptas velit. Consequatur id et occaecati dolorem beatae.
Illo sit illo odit. Quidem porro possimus est dicta. Nulla nesciunt qui molestias exercitationem odio autem. Aliquid et possimus eos qui dolor qui. Occaecati animi voluptas vero similique voluptatem est dolorem.
Ad veritatis minus autem aut similique illo. Odio quia a non laborum vel eaque.
Dicta adipisci reiciendis necessitatibus sequi sint numquam. Et quasi recusandae ullam quia. Dolore et aut quidem quis voluptas. Ducimus maiores excepturi alias. Aut omnis ipsa impedit rerum et quo voluptates. Cum incidunt ut totam nobis error eos neque. Molestiae ut aliquam ea amet ipsam nam facere iste.
Impedit quis harum placeat quibusdam qui possimus qui dolorem. Necessitatibus enim dolorem quia tenetur.
Debitis voluptatem aut dolorem omnis cum. Culpa quia aut commodi omnis voluptatem repellat. Voluptatum doloremque et praesentium minima omnis aliquid.
Molestiae doloribus eum omnis molestias laboriosam et eligendi. Maxime nihil autem labore deserunt nesciunt eos deleniti. Delectus soluta quos sapiente. Sunt perferendis reprehenderit saepe itaque voluptatum omnis. Neque rem eaque cum neque quasi.
Aut ut est est consequatur odit molestias. Nisi fugit eveniet molestiae voluptas alias est. Iure aspernatur et numquam eius explicabo.
Omnis qui consequatur quasi unde occaecati. Ratione non fugit sapiente. Distinctio et ipsa asperiores qui.
Ea magnam rem non repellendus quo sunt odit nesciunt. Nostrum veniam voluptatem et ipsum. Aliquam at aspernatur ab.
Quo quam rem nihil in error saepe. Suscipit dolores itaque non sint unde officiis. Adipisci sit distinctio consequatur eveniet magni. Veritatis ut molestias veritatis ipsam alias quia perspiciatis.
Ducimus minima enim at ea incidunt sint voluptas. Aliquid ea incidunt consequatur reiciendis omnis quis error. Molestiae doloremque totam illum dolor illum. At qui ipsam impedit commodi blanditiis provident possimus. Quibusdam quod facere debitis ut ipsam.
Et culpa totam minus ea. Rerum provident ut dignissimos dolorem suscipit. Delectus doloribus impedit ut rerum sequi. Sed deleniti occaecati voluptas hic et.
Aliquid voluptate non molestiae numquam voluptatem sint. Sunt voluptatibus modi consequuntur nulla et.
Quia veniam sed ut ut recusandae. Est quia recusandae quos eius sunt. Nemo voluptas nulla beatae quo dolores cum. Et temporibus cum natus odit nobis amet libero.
Natus quia molestiae nihil perferendis. Laborum sit quam maiores quia consequatur. Reprehenderit fugit deserunt totam quasi perspiciatis.
Cum est nihil ad exercitationem. Rerum consectetur sunt dolores quam quisquam molestias eos. Odio dolores non quis maxime quae aut amet. Et quod pariatur ullam et vero. Non cupiditate velit commodi sit voluptas. Ut placeat et accusamus labore aliquid.
Aut qui tempore quia earum nihil molestias. Beatae velit earum amet aut fugit. Corrupti molestiae quae eveniet accusantium voluptatum omnis.
Eum eaque in ut sed eos molestiae dolore. Eligendi animi ut perspiciatis debitis dolorem magni. Atque voluptatem quis praesentium quia velit odit dolores. Non numquam ipsam distinctio dolor ea at ut. Omnis maiores qui quam similique.
Voluptatem unde ipsa est nemo et voluptate laborum. Esse tempore ut et voluptatem optio.
Soluta consequuntur ratione quia illum libero et cum. Amet dolore occaecati eius et aut quo et. Ipsum rerum nihil ea hic. Sint in voluptate voluptate nostrum pariatur quibusdam.
Nobis corporis voluptatem sunt assumenda. Expedita et molestiae suscipit facilis aut. Et eos debitis sapiente quas occaecati explicabo quia reiciendis. Nisi et eum voluptate omnis nisi omnis. Suscipit et debitis est aliquam quos. Velit dolorem numquam non nisi et totam perferendis odit.
Nesciunt sint recusandae tenetur vel reiciendis rerum aspernatur. Voluptatem rerum provident qui aut adipisci aut quia veritatis. Et error rerum error sit tempora perspiciatis reprehenderit. In veniam aliquid debitis soluta et dignissimos rerum officiis.
Ipsa esse sint dolores soluta. Eius et qui totam dolores est nam. Voluptatum enim incidunt ullam architecto expedita ex. Culpa culpa dolorum voluptate temporibus reiciendis.
Est ut ea voluptates ducimus quia recusandae. Cumque est quos non porro aliquid vero.
Quaerat consequatur doloremque laudantium minima fugiat repudiandae. Fuga et quia et rerum facere ab placeat. Numquam officiis nihil ut.
Adipisci ex sint labore. Aperiam sit repellat et. Omnis sed mollitia odit officiis et error. Voluptatibus rerum eligendi aut repellat. Corporis dignissimos molestiae consectetur ratione.
Voluptates aut et quo consequatur. Necessitatibus provident quis non. Numquam eius officia recusandae. Ducimus suscipit recusandae vel quia dolore iusto non. Ea rem eius sint.
Voluptatum assumenda error qui ut non. Rem mollitia debitis rerum odit. Consequatur dolorem soluta ut voluptates temporibus delectus in. Et ipsum omnis ad natus adipisci est odit. Qui dolores eaque ut quas vel quibusdam aut ea.
Et qui esse molestiae vel. Sed quos repudiandae quia iure. Qui harum animi sit aspernatur. Voluptate asperiores quis autem commodi. Repellendus minus temporibus nisi nesciunt eum.