Weighted present values in DCF models
I am writing my thesis about different DCF models and are wondering, why the present values (PVs) of cash flows decrease, the closer they are to the present due to time value of money, despite more certainty w.r.t. both growth and discount rate. Wouldn't it be reasonable to multiply the growing PVs of future positive cash flows by declining weight variables to account for the rising uncertainty of PVs that are further into the future? By adding periods to the planning or transition phase, I could reduce the share of a high terminal value in total present value; however, that wouldn't solve the problem of rising PVs with time without accounting for higher uncertainty.
Many thanks in advance for any help!
By using a probability weighted DCF, you are not only assigning a higher weight to the early cash flows, but you are assigning a weight to your own assumptions.
This creates a few issues: (1) a DCF is already 1% historical data 99% assumptions, by assigning an arbitrary weight to the cash flows you are adding an extra assumption (2) your inability to predict cash flows is not representative of the firm’s ability to generate them - this will heavily undervalued the underlying equity. There millions of reasons why (2) is troublesome, you are discounting your own estimation of cash flows for no real reason. Assume that you assign a probability of p=.8 to forward year 1 cash flows. You are reducing your own assumptions by 20% simply because you don’t trust your assumptions. The further you go, the more you will discount the cash flows. Forward year 5, p=.1 (cash flows reduced by 90%.
The discount rate is necessary because it represents systematic risk across the capital structure + the reward for tvm (risk free rate).
If your intention is to use probabilities, do so with individual assumptions when coming up with your bear/base/bull cases. Instead of outright weighting the cash flows, weight the assumptions that got you there. For example, if you are looking at forward year 5 Capex, in order to reflect uncertainty, compute Capex = p(high Capex) + (1-p)(Low Capex) and so on.
Biotech already uses probability weighted DCFs, but it does so due to the high risk/high reward nature of the industry.
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