May 16, 2019 //
In the previous article we examined the popular EBITDA Multiple approach to estimating a company’s value. Discussing its benefits and limitations, we concluded that while the EBITDA Multiple worked as a starting point, serious buyers and sellers needed a more nuanced valuation technique like Discounted Cash Flow (DCF).
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. As the Corporate Finance Institute explains:
“The “comparables” valuation method provides an observable value for the business, based on what companies are currently worth. Comps are the most widely used approach, as they are easy to calculate and always current. The logic follows that, if company X trades at a 10-times P/E ratio, and company Y has earnings of $2.50 per share, company Y’s stock must be worth $25.00 per share (assuming its perfectly comparable).
“A DCF analysis is performed by building a financial model in Excel and requires extensive detail and analysis. …. However, the effort required for preparing a DCF model will also result in the most accurate valuation. A DCF model allows the analyst to forecast value based on different scenarios and perform sensitivity analysis.”[1]
Calculating the DCF Valuation
Summarized in Figure 1, we determine a DCF valuation as follows:
- Estimate the company’s discretionary cash flow each year for the forecast period (usually 3-5 years)
- Calculate a terminal value, which covers the post-forecast period (annual normalized discretionary cash flow / capitalization rate)
- Using a rate of return that reflects business risk as well as industry, economic and market factors, discount each year’s forecasted discretionary cash flow and the terminal value to determine their present value
- Add the present value of existing tax pools to calculate the business’s enterprise value
- Deduct interest bearing debts and equivalent liabilities to get the equity value
- Adjust further as needed to reflect any factors not reflected in the forecast cash flows
Clearly the accuracy of the valuation hinges on the quality of the discretionary cash flow estimates, and the underlying operating results forecasts. Some things to consider:
- Who developed the forecast and why? Look for level of experience, possible biases, level of input from each department, and how business leaders were involved in preparing and vetting the forecast.
- Is the time period appropriate? Three to five years is normal, but business specific factors or industry cyclicality may dictate a shorter or longer period.
- How detailed is the forecast? Ideally including income statement, balance sheet, and statement of cash flows, the forecast should reflect carefully selected assumptions, proper breakdown of both revenues and costs, and analytical rigour.
- What variables, economic drivers, and assumptions are built in, and are they internally consistent across the various financial statements? Revenue assumptions typically include future sales volume, selling prices, currency exchange rates, and risks to projected returns. On the expense side, look for the breakdown between fixed and variable costs, whether they are one-time or ongoing, inflation expectations, and the costs associated with revenue growth. Assumptions should also cover capital expenditures related to sustaining and growing the business, and levels of working capital.
Limitations and Strengths
Other common issues that can derail a DCF valuation are:
- Inadequate estimate of costs, most commonly a failure to consider the expenses attached to revenue growth, and the assumption that a business can indefinitely leverage its fixed cost structure.
- Issues with the terminal value calculation, often stemming from assumptions about the normalized discretionary cash flows or growth rates that prove to be unsustainable over time.
- Technical errors in calculation arising from the complexity of the DCF calculation itself or inconsistent application of discount rates and inflation rates.
- An overly conservative or optimistic discount rate. Common practice calls for beginning with the long-term bond rate and adjusting it to reflect risk in the company and industry. But not all investors follow this practice — Berkshire Hathaway’s Warren Buffet and Charlie Munger discount all cash flows at the long-term bond rate to facilitate comparison across opportunities, then buy companies for substantially less than their intrinsic value.
Nevertheless, DCF remains the preferred valuation methodology. In contrast to methods relying on public company information and comparable multiples, DCF requires that both buyer and seller are adequately informed of all material facts, regardless of whether they are in the public domain. It fits well with a rigorous due diligence process, and forces detailed analysis of all relevant fact-specific variables. It also breaks out these variables for separate consideration and analysis, rather than rolling them all into an EBITDA or multiple.
Questions of Judgment
When developing the foundational forecast models or making later-stage adjustments to arrive at the value of a business, there are countless decision points where business and financial judgment come into play. Whether you are buying or selling, working with a professional can help you think through the issues. Examples include:
- When should R&D investments be treated like a capital investment — reflected on the balance sheet and amortized over time — versus an expense, and how do you properly distinguish between non-recurring new product development and maintenance R&D?
- What is a maintenance, service agreement, marketing agreement, restructuring or contract expense “normal” (i.e. ongoing) versus abnormal?
- How best to recognize current expenses meant to generate future benefits — for example hiring 3 salespeople one year to generate future profitability?
- Should the P&L show all expenses related to owned real estate, or should they be removed from the income statement and replace with fair market value rent?
These examples — and questions of judgment more generally — lead to a discussion of accounting versus pro forma numbers, and their respective roles in business valuation. We will explore this topic in the next article.
A final word about DCF methodology: regardless of how detailed your model, the valuation yielded by any technique is an estimate at best. The future is inherently uncertain. While we always advocate best efforts in modeling DCF, we take the results with a grain of salt. As Warren Buffet has said, “it’s better to be approximately right than precisely wrong.”
[1] https://corporatefinanceinstitute.com/resources/knowledge/valuation/valuation-methods/
