How DCF accounts for assets value?
Could someone please explain or refer to the link on how DCF accounts for the value of assets? For example, when analyzing companies we can do FCF based perpetuity model and get the intrinsic value of the company. I am confused on how underlying assets of the company are treated in this case. Are they being ignored by DCF (i.e only care for cash flows) or accounted in some indirect way?
In my head the value of a company is assets + future cash flows.
Thank you in advance for help. I really appreciate it.
by very definition an asset is something that will provide future benefit (e.g., cash flows), hence no need to delineate between the two. the replenishment / investment of which is accounted for within Capex
You're valuing the assets in reference to their future expected cash flows. Those assets are valuable insofar as they provide a future benefit. That benefit is calculated and measured in currency. Valuing the assets + their respective cash flows, if it were possible to even do this at all (since the assets can only be valued by referring to their expected cash flows), would constitute double counting.
I'm assuming that your confusion stems from the different accounting treatment of assets, namely that they have historical book values and are also marked-to-market (fair value/market value). The book values are irrelevant when it comes to the actual value of those assets; book values represent past economic conditions. In other words, those values no longer represent the future benefit stream of the underlying asset.
Hope this helps.
There was a question on here yesterday about why you subtract cash in computing enterprise value - this is essentially the opposite of that question.
The answer is that a DCF using unlevered free cash flows will give you the enterprise value of the business, which already takes into account the value of operational assets - the value of a firm's core, operational assets is embedded in the cash flows that the business produces.
The simple way to think about this - say I have a business which produces widgets and I have one machine which lasts forever, costs nothing to run, and produces $10 of widgets per year. At a 10% discount rate, using a perpetuity DCF, the business is worth $100. Suppose the machine cost $50 and I could sell it at any time for $50. That doesn't matter - the value of the business as a going concern (as an operating company) is still only $100, because we can't sell the machine and yet still collect $10 per year in cash flow. On the other hand, we could liquidate the business (sell the machine) and get $50, but in this case the business is worth more as a going concern. But the key principle is that adding the liquidation value of the firm's assets to your DCF output would be double counting those assets.
On the other hand, most firms have assets which they hold but are not required to run the business. For example, excess cash, securities, sometimes real estate or land, etc. The value of these should be added to your DCF output (Enterprise Value) to get the total value of owning the firm (the value of Debt + Equity + Pref + other ownership claims on the business).
The rule of thumb is - if you are including the income generation of the asset in your projected cash flows for the DCF, then you shouldn't add it (that would be double counting). If, on the other hand, it's an excess asset not accounted for your DCF, then it should be added to determine the value of the firm's securities.
This is a really good explanation, thanks
Wow. Thanks a lot WSO community. Very clear and sufficient explanation. Much appreciated.
Why does a DCF not consider a firm's assets? (Originally Posted: 06/10/2013)
Hypothetical Scenario:
A company has $100MM of assets but for some reason its cash flow is only $1000. Even if you put generous assumptions for its growth rate/discount rate its DCF valuation will be nowhere close to the value of its assets.
Wouldn't a DCF valuation make more sense if you were to make terminal value = net tangible book value?
Why would that ever happen? An asset is valued on its ability to generate cash (generally), so this scenario would point to a lot of balance sheet writedowns coming up.
In your scenario, the logical answer is that those assets aren't actually worth $100m.
The DCF valuation method is based on the principle that the value of the firm or asset is the present value of all future cash flows generated by that particular firm or asset. It wouldn't make sense to arbitrarily value the assets at 100mm if they can only generate $1000/ year(assuming a normal discount rate). You are probably thinking that the asset is worth 100mm based on the book value from the balance sheet. But as we all know, the price paid is not necessarily correctly valued.
What if your parents never met? Early/R&D phase. There would be a target date to begin generating cash flow. Talk to management about that date and expected revenue once production begins. The valuation would be based on the Time Value of Money + Likelihood of Positive CFs + Terminal Value once CFs begin.
Generally, I agree with everyone here. In the case when a DCF valuation can't possibly show more value than the current FMV of the tangible assets, shut the business down and sell off the $100mm of assets tomorrow. This scenario would assume that the value of these assets can be better utilized by another company (which touches on what Oreos was saying).
As far as using the sale price of tangible assets as the terminal value, I have done this in a DCF once before for a very specific situation. This was for a pit of rock. The company's plan was to mine the rock until depletion, then sell off the equipment. Our client didn't have any branding or any other intangibles that would be worth anything in 10 years and because there wasn't any rock left to sell, only the value of the equipment was left. Figuring out the future fair value of the equipment is another issue...
Sounds like a nice chapter 7 to me.
If those are non operating assets (ie. non contributing to the cash flow generation) I would add their value to the EV
Thanks for a worthless response to an old thread
It's not immediately straightforward why cash is subtracted in this formula, so people tend to use the House analogy - is a House with 1000$ inside really add more value to you than a house with nothing? Yes, you could pay an extra $1000 for $1000 in cash, but then you'd be doing a pretty null transaction.
Hi,
In DCF, should we add the initial equity to the valuation ?
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