Advantages
| Disadvantages
|
Easy to understand and apply Fewer assumptions used than with DCF Better captures current mood of market
| Choice of multiples sometimes subjective Difficult to find comparables with identical, or at least similar, revenue drivers Assumption that market accurately values the peer group
|
Which Model to Use
The choice between these two alternative valuation models will depend on specific factors, such as availability and accuracy of the inputs (revenue drivers,businesscycles, etc.).
Dividend-Paying, Mature and Stable Companies
The DDM model is best applied for stable and mature public companies that pay dividends. For example, BP plc. (BP), Microsoft Corporation (MSFT)and Wal-Mart Stores, Inc. (WMT) pay regular dividends and can be characterized as stable and mature businesses. Therefore, the DDM can be applied to value these companies.
The FCF model can be used to calculate the valuation of companies that do not pay dividends or pay dividends in an irregular fashion. This model is also applied for those companies with a dividend growth rate that does not properly capture the earnings growth rates.
Companies with Diverse Revenue Drivers
When a company valued has a diversified revenue source, the free cash flow method can be a better approach than the comparable method, simply because finding a true comparison can be problematic. Today there are a number of large-cap companies with diversified revenue drivers. This feature makes it challenging to find a relevant peer group, company, or even industry multiples.
For example, both Canon Inc. (CAJ) and Hewlett-Packard Company (HPQ) are large manufacturers of printing machines for business and personal use. However, HP’s revenue also is derived from the computer business. HP and Apple are both competitors in the computer business, but Apple derives its revenue mostly from sales of smartphones and its built-in app store.
Apparently, neither Canon and HP, nor HP and Apple, can be in a peer group in order to use a peer group multiple.
Valuation of Private Companies
There is no straightforward choice of valuation model for private companies. It will depend on the maturation of the private company and the availability of model inputs. For a stable and mature company, the comparables method can be the best option.
In general, it is very complicated to get the inputs required for the DCF model from private companies. The beta, which is one of the key inputs for a returns estimation of a private company, is best estimated using comparable firms’ betas. This makes it challenging to apply the DCF model.
Private companies do not distribute regular dividends, and therefore, future dividend distribution is unpredictable. The free cash flow model would also be unreliable for valuing relatively new private companies due to the high uncertainty surrounding the business itself. However, in the early stages of a private company with a high growth rate, the FCF model may be a better option for common equity valuation.
Valuation of Cyclical Companies
Cyclical companies are those that experience high volatility of earnings based on business cycles. This can lead to difficulties in forecasting future earnings. Forecasting earnings is a base for theDCF models (be it DDM or FCF model). The relationship between risk and return implies that increased risk shall be accounted for in an increased discount rate, making the model even more complicated. As a result, if an investor chooses the DCF model to value a cyclical company, they will most likely get inaccurate results.The comparable method can better solve the cyclicality problem.
The Bottom Line
A mix of factors impacts the choice of which equity valuation model to choose. No one model is ideal for a certain type of company.Ideally, both models should yield close results, if not the same. The DCF model requires high accuracy in forecasting future dividends or free cash flows, whereas the comparables method requires the availability of a fair, comparable peer group (or industry), since this modelis based on the law of one price, which states that similar goods should sell at similar prices (thus, similar revenues earned from the similar sources should be similarly priced).
FAQs
The DCF model requires high accuracy in forecasting future dividends or free cash flows, whereas the comparables method requires the availability of a fair, comparable peer group (or industry), since this model is based on the law of one price, which states that similar goods should sell at similar prices (thus, ...
Does DCF or comps give a higher valuation? ›
Usually, DCF will give a higher valuation. Unlike DCF, in LBO analysis, you won't get any cash flow between year one and the final year. So the analysis is done based on terminal value only. In the case of DCF, the valuation is done both based on cash flows and the terminal values; thus, it tends to be higher.
What is the difference between DCF valuation and multiples valuation? ›
Multiples are more suitable for quick and simple valuations, or for comparing relative values across a group of similar companies or assets. DCF is more suitable for detailed and comprehensive valuations, or for capturing the unique value drivers and risks of a specific company or asset.
Why discounted cash flow is better in valuation? ›
The main advantages of a discounted cash flow analysis are its use of precise numbers and the fact that it is more objective than other methods in valuing an investment. Learn about alternate methods used to value an investment below.
When would you not use a DCF in a valuation? ›
The main Cons of a DCF model are:
Very sensitive to changes in assumptions. A high level of detail may result in overconfidence. Looks at company valuation in isolation. Doesn't look at relative valuations of competitors.
Why is DCF better than relative valuation? ›
DCF Valuation truly captures the underlying fundamental drivers of a business (cost of equity, weighted average cost of capital, growth rate, re-investment rate, etc.). Consequently, this comes closest to estimating intrinsic value of the asset/business. Unlike other valuations, DCF relies on Free Cash Flows.
Which valuation method is the most accurate? ›
Discounted Cash Flow Analysis (DCF)
In this respect, DCF is the most theoretically correct of all of the valuation methods because it is the most precise.
What is a disadvantage of using comparables method for equity valuation? ›
It is difficult to identify transactions or companies that are comparable. There is usually a lack of a sufficient number of comparable companies or transactions. It is less flexible compared to other methods.
When would you use a DCF in a valuation? ›
What Is DCF Used For? A discounted cash flow valuation is used to determine if an investment is worthwhile in the long run. For example, in investment banking, a DCF valuation is used to determine if a potential merger or acquisition is worth it. Additionally, DCF valuation is used in real estate and private equity.
Why do some investors prefer the DCF method to other methods of valuation? ›
One of the most significant advantages of the DCF valuation model is that it returns the closest thing private practices can get to an intrinsic stock market value. By valuing the business based on the discounted value of future cash flow, valuation experts can arrive at a fair market value.
Disadvantages of using the Discounted Cash Flow method
This means that the quality of your valuation is extremely sensitive to the input variables of the formula (such as the WACC and the growth rate), yet also on your ability to create an accurate forecast of your firm's future performance.
Why use WACC to discount cash flows? ›
One solution for companies is to use their weighted average cost of capital (WACC). The WACC reflects the risk to the future cash flows received by an organisation from its operations. If two companies are expected to produce the same future cash flows but one has a lower WACC, then it will be more valuable.
What are the key drivers of DCF? ›
The choice of key drivers for sensitivity analysis in DCF may vary depending on the context and purpose of your valuation. However, some common key drivers are revenue growth, operating margin, discount rate, and terminal value.
Does Warren Buffett use DCF? ›
Therefore, value investors can use Warren Buffett's DCF valuation approach, which is theoretically one of the most accurate ways to estimate a firm's intrinsic value, to approximately estimate whether a stock is attractively valued or not at its current price.
What are the weakness of discounted cash flow? ›
Disadvantages of discounted cash flow:
A lot of assumptions have to be made which make it prone to errors when estimating future cash flows and determining an appropriate discount rate. The discount rate used is fixed throughout the life of the project which may not reflect the future value of today's money.
Why don't we use DCF to value banks? ›
The DCF method may be quite popular, but it has a major flaw: it does not show any flexibility of cash flows. In the real world, capital investment projects can be changed at any time, and hence, the DCF technique is worthless as it cannot adapt to the changing circ*mstances.
What are the three valuation methods? ›
Three main types of valuation methods are commonly used for establishing the economic value of businesses: market, cost, and income; each method has advantages and drawbacks.
Which method of valuing a business is best why? ›
Discounted Cash Flows
This technique is highlighted in the Leading with Finance as the gold standard of valuation. Discounted cash flow analysis is the process of estimating the value of a company or investment based on the money, or cash flows, it's expected to generate in the future.
How is DCF different from Ebitda valuation? ›
Both methods determine the value of a business by calculating a present value of expected future cash flows. But where the EBITDA Multiple is primarily concerned with relative value across comparable transactions, DCF focuses on understanding the intrinsic value of a specific business.
When should a valuer use the comparable method? ›
The Comparison method is used to value the most common types of property, such as houses, shops, offices and standard warehouses. Ideally the market should be stable and there should be multiple, recent lettings/sales of comparable properties (same size, location, condition etcetera).
But this process also has disadvantages, some of them are: It is easily influenced by non-fundamental factors. Data not easily available for private companies. It can be difficult for you to find the correct data for your company to compare due to many reasons.
Why not always use multiples based valuation methods? ›
One of the disadvantages of valuing stocks using multiples is that determining the appropriate multiple to use for a given company can be highly subjective because truly comparable companies rarely exist.
What is not an advantage of comparable transactions analysis? ›
However, using comparable transactions also has some drawbacks. One of the major challenges is finding enough relevant and reliable data to perform the analysis. You may not have access to the details of the deal, such as the purchase price, the financing structure, or the terms and conditions.
Is DCF method good for start up valuation? ›
Discounted Cash Flow (DCF)
For most startups—especially those that have yet to start generating earnings—the bulk of the value rests on future potential. Discounted cash flow analysis then represents an important valuation approach.
What valuation method usually gives the highest valuation and why? ›
Precedent transactions are likely to give the highest valuation since a transaction value would include a premium for shareholders over the actual value.
How accurate is DCF valuation? ›
The DCFF method is considered a reliable method because it takes into account all of the cash flows generated by a company, including its operating cash flows, financing cash flows and any changes in working capital.
What are the reasons for using discounted cash flow techniques? ›
Discounted cash flow helps investors evaluate how much money goes into the investment, the timing of when that money is spent, how much money the investment generates, and when the investor can access the funds from the investment.
Do you use DCF in venture capital? ›
DCF is one of the most common methodology used by investors worldwide to value businesses. Indeed, DCF gives an intrinsic valuation by using a business' expected cash flows. Yet, venture capital investors very rarely use DCF to value startup.
Why do you use FCF in a DCF instead of Ebitda? ›
When it comes to analyzing the performance of a company on its own merits, some analysts see free cash flow as a better metric than EBITDA. 1 This is because it provides a better idea of the level of earnings that is really available to a firm after it covers its interest, taxes, and other commitments.
When should you not use WACC? ›
Also, WACC is not suitable for accessing risky projects because to reflect the higher risk, the cost of capital will be higher. Instead, investors may opt to use adjusted present value (APV), which does not use WACC.
Unfortunately, the WACC is flawed as the discount rate because it carries far too many false assumptions, relies on beta as a form of risk, and can be misleading due to the tax shield on the cost of debt. Individual/retail investors should therefore avoid using the WACC as their discount rate for valuation purposes.
What is the relationship between WACC and DCF? ›
DCF Usages
Also, a company's own weighted average cost of capital (WACC) over a period of five to 10 years can be used as the discount rate in DCF analysis. WACC calculates the cost of how a company raises capital or funds, which can be from bonds, long-term debt, common stock, and preferred stock.
What are the 3 steps of DCF? ›
Steps in the DCF Analysis
Calculate the TV. Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present value. Calculate the equity value by subtracting net debt from EV. Review the results.
What are the three discounted cash flow techniques? ›
It requires calculation of a company's free cash flows (FCF) in addition to the net present value (NPV) of these FCFs. There are three major concepts in DCF model: net present value, discounted rate and free cash flow.
What are the two types of DCF models? ›
The most common variations of the DCF model are the dividend discount model (DDM) and the free cash flow (FCF) model, which, in turn, has two forms: free cash flow to equity (FCFE) and free cash flow to firm (FCFF) models.
What is the DCF of Coca Cola stock? ›
This DCF valuation model was created by Alpha Spread and was last updated on Mar 31, 2023. Estimated DCF Value of one co*kE stock is 408.12 USD. Compared to the current market price of 535.08 USD, the stock is Overvalued by 24%.
Is DCF just NPV? ›
The difference between discounted cash flow and net present value is that net present value (NPV) subtracts the initial cash investment, but DCF doesn't. Discounted cash flow models may produce incorrect valuation results if forecast cash flows or the risk rate are inaccurate.
What is the DCF of Berkshire Hathaway stock? ›
DCF Value. This DCF valuation model was created by Alpha Spread and was last updated on Apr 28, 2023. Estimated DCF Value of one BRK. B stock is 361.34 USD.
What is the biggest drawback of the DCF? ›
4 The most prevalent is that the uncertainty with cash flow projection increases for each year in the forecast—and DCF models often use five or even 10 years' worth of estimates. The outer years of the model can be total shots in the dark.
Is a higher discounted cash flow better? ›
The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash. The first step in conducting a DCF analysis is to estimate the future cash flows for a specific time period, as well as the terminal value of the investment.
Discount cash flow analysis:
Discounted cash flow (DCF) analysis is a common valuation method used in private equity funds to estimate the present value of a company's expected future cash flows. The DCF analysis takes into account the time value of money and the risks associated with the company's future cash flows.
Do asset managers use DCF? ›
The common methods used to value asset management firms are the discounted cash flow, the multiples, and the Dividend Discount Model, with some adaptions.
Can you use a DCF for an unprofitable company? ›
Since price-to-earnings (P/E) ratios cannot be used to value unprofitable companies, alternative methods have to be used. These methods can be direct—such as discounted cash flow (DCF)—or relative valuation.
Which valuation method gives higher valuation company comps and transaction comps? ›
Generally, however, transaction comps would give the highest valuation, since a transaction value would include a premium for shareholders over the actual value.
What valuation methodology gives you the highest valuation lowest? ›
Beyond that, a DCF could go either way and it's best to say that it's more variable than other methodologies. Often it produces the highest value, but it can produce the lowest value as well depending on your assumptions. 3. When would you not use a DCF in a Valuation?
Does DCF give you equity or enterprise value? ›
A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity.
Which valuation method leads to highest valuation? ›
Precedent transactions are likely to give the highest valuation since a transaction value would include a premium for shareholders over the actual value.
What are the 3 major valuation methodologies? ›
There are three approaches to valuing a company: the asset approach, income approach, and market approach. Within each approach, there are several commonly accepted methods that the valuator may choose to employ in valuing the business.
What are the major disadvantages of the comparable company analysis? ›
But this process also has disadvantages, some of them are:
- It is easily influenced by non-fundamental factors.
- Data not easily available for private companies.
- It can be difficult for you to find the correct data for your company to compare due to many reasons.
Expert Answer. When a buyer is interested in purchasing a business that is found to witness rapid growth, it is suggested that the best method of business valuation is the future earnings method. This method helps in determining the worth of a business on the basis of forecasted future earnings.
Market capitalization is the simplest method of business valuation. It is calculated by multiplying the company's share price by its total number of shares outstanding.
Can you use DCF to value a company? ›
DCF helps to calculate how much an investment is worth today based on the return in the future. DCF analysis can be applied to investments as well as purchases of assets by company owners. DCF is a valuation method that can be used for privately-held companies.
