Projection Period for DCF Model
I've learnt the key aspects of DCF analysis, but one thing that just sprung to mind is, what factors dictate how many years you choose as the projection period?
From WSO user @Solidarity" :
In a DCF, you "grow" the company until it reaches a theoretical steady-state e.g. you could get away with doing 3-5 year DCF on GE or Lockheed, but you'd need a 10+ yr DCF on a newly IPO'd company
What Happens If You Value a Company Over a Longer Time Period?
Obviously the point of the model reduces the FCF's to NPVs, so every year the denominator in the equation for EV is getting larger. But, if I valued a company over 20 years, wouldn't it 99% of the time be higher than if I projected it in 10 years? Doesn't this always lead to differences in EV's across the market?
Paying for Future Growth
From WSO user @Solidarity" :
- Start thinking about this from a theoretical standpoint -- the further out you project, the higher the proportion of value lies in the PV of the FCF's over the projection period vs. the terminal value (this is also one of the conundrums of 5-year DCF's... so much of the value is locked into the terminal value).
- From a practical standpoint, using a 20 yr period = lower exit multiple / lower perpetuity growth rate.
- Remember basic time value of money: you're paying for future growth, and typically, older companies in established industries will have attenuated growth prospects.
Highest Valuation Wins?
Couldn't I just win in a pitch by giving the highest valuation by projecting for an infinite number of years?
Under-promise and Over-deliver
From WSO user @Solidarity" :
- The bank that pitches the highest offering price rarely wins the mandate.
- It comes down to a myriad of factors, including execution capability and relationship with management (arguably most important).
- Additionally, it's always better to under-promise and over-deliver: you don't want to come back and tell the CEO that you can only get $40 per share when you promised $50--or even worse, the stock tanks immediately post-offering (ruins your credibility and it's just bad business).
- Personally, I think it's better to use comps as a primary form of valuation and the DCF as a sanity check.
Recommended Reading
- Discounted Cash Flow DCF Model Template
- EBITDA vs Operating Cash Flow vs Free Cash Flow
- Discounted Cash Flow Valuations (DCF): Academic Exercise, Sales Pitch or Investor Tool
- Investment Banking Interview: Walk Me Through a DCF
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terminal value
You project out until business is "stable." That is typically five years in modeling. That being said, I've projected out 20 years and took the TV at FY+20. If business is stable at FY+5 but you take it out another 10 years, then the value should be the same as if you capitalized it at FY+5.
But if I was using the terminal value method, part of that equation is LTM of the last 12 months * projected LTM of the projection period? So the number of years directly impacts the TV ?
jack - thank you. Doesn't a business become stable when you can't really predict FCF's any longer? So it stays around the same value?
I guess I need to research this a bit more, understand the concept but not the how it'd be implemented.
In a DCF, you "grow" the company until it reaches a theoretical steady-state e.g. you could get away with doing 3-5 year DCF on GE or Lockheed, but you'd need a 10+ yr DCF on a newly IPO'd company
No. Start thinking about this from a theoretical standpoint -- the further out you project, the higher the proportion of value lies in the PV of the FCF's over the projection period vs. the terminal value (this is also one of the conundrums of 5-year DCF's... so much of the value is locked into the terminal value). From a practical standpoint, using a 20 yr period = lower exit multiple / lower perpetuity growth rate. Remember basic time value of money: you're paying for future growth, and typically, older companies in established industries will have attenuated growth prospects.
You need to work this out for yourself from a mathematical standpoint...
The bank that pitches the highest offering price rarely wins the mandate. It comes down to a myriad of factors, including execution capability and relationship with management (arguably most important). Additionally, it's always better to under-promise and over-deliver: you don't want to come back and tell the CEO that you can only get $40 per share when you promised $50--or even worse, the stock tanks immediately post-offering (ruins your credibility and it's just bad business).
Personally, I think it's better to use comps as a primary form of valuation and the DCF as a sanity check.
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