The Income Approach to Valuation – Discounted Cash Flow Method
Investors in publicly-traded companies have the luxury of knowing the value of their investment at virtually any time. An internet connection and a few clicks of a mouse are all its takes to get an up-to-date stock quote. Of all U.S. companies, however, less than 1% are publicly-traded, meaning that the vast majority of companies are privately-held. Investors in privately-held companies do not have such a readily available value for their ownership interests. How are values of privately-held businesses determined, then? Each month, this eight blog series will answer that question by examining a key component of how ownership interests in privately-held companies are valued.
There are two income-based approaches that are primarily used when valuing a business, the Capitalization of Cash Flow Method and the Discounted Cash Flow Method. These methods are used to value a company based on the amount of income the company is expected to generate in the future.
The Capitalization of Cash Flow Method is most often used when a company is expected to have a relatively stable level of margins and growth in the future – it effectively takes a single benefit stream and assumes that it grows at a steady rate into perpetuity. The Discounted Cash Flow method, on the other hand, is more flexible than the Capitalization of Cash Flow Method and allows for variation in margins, growth rates, debt repayments and other items in future years that may not remain static. As a result, the Capitalization of Cash Flow Method is typically applied more often when valuing mature companies with modest future growth expectations. The Discounted Cash Flow Method is used when future growth rates or margins are expected to vary or when modeling the impact of debt repayments in future years (although it can still be used in same sort of “steady growth” situations in which the Capitalization of Cash Flow Method can be applied).
More information related to the Discounted Cash Flow Method is provided below along with an example:
Discounted Cash Flow Method – The Discounted Cash Flow Method is an income-based approach to valuation that is based upon the theory that the value of a business is equal to the present value of its projected future benefits (including the present value of its terminal value). The terminal value does not assume the actual termination or liquidation of the business, but rather represents the point in time when the projected cash flows level off or flatten (which is assumed to continue into perpetuity). The amounts for the projected cash flows and the terminal value are discounted to the valuation date using an appropriate discount rate, which encompasses the risks specific to investing in the specific company being valued. Inherent in this method is the incorporation or development of projections of the future operating results of the company being valued.
Distributable cash flow is used as the benefit stream because it represents the earnings available for distribution to investors after considering the reinvestment required for a company’s future growth. The discounted cash flow method can be based on the cash flows to either a company’s equity or invested capital (which is equal to the sum of a company’s debt and equity). A “direct to equity” discounted cash flow method arrives directly at an equity value of a company while a “debt-free” discounted cash flow method arrives at the invested capital value of a company, from which debt must be subtracted to arrive at the company’s equity value. A brief summary of some of the primary differences between a “direct to equity” and a “debt-free” discounted cash flow analysis are presented below:
An example of a “direct to equity” discounted cash flow analysis is presented below:
To summarize, the Discounted Cash Flow Method is an income-based approach to valuation that is based on the company’s ability to generate cash flows in the future.
What is a Discounted Cash Flow Model?
Discounted cash flow (DCF) is used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment, often during due diligence. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
Discounted Cash Flow (DCF) Valuation estimates the intrinsic value of an asset/business based upon its fundamentals.
Intrinsic Value of a business is the present value of the cash flows the company is expected to pay its shareholders. DCF Valuation is the basic foundation upon which all other valuation methodologies are built.
To perform Relative Valuation correctly, we need to understand the fundamentals of DFC Valuation. Similarly, to apply option pricing modelling techniques, we often need to begin with a discounted cashflow valuation. Anyone who understands DCF technique will be able to analyze and apply all other valuation methodologies, thus underlying the importance of DCF Valuation.
Discounted Cash Flow Valuation is based upon expected future cash flows of the company and its associated discount rate, which is a measure of the risk attached to the business in general and company in particular. Given these mandatory requirements to arrive at DCF Valuation, this approach is easiest to use for assets, businesses, etc. whose cashflows are currently positive and can be forecasted with some reliability, and where a proxy for risk that can be used to obtain discount rates is available. The farther we depart from this idealized setting, the more difficult and less reliable DCF Valuation will be.
Given its increasing significance in business valuations, let’s look at some of the key advantages and disadvantages associated with DCF 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. To a larger extent, Free Cash Flows (FCF) are a reliable measure that eliminate the subjective accounting policies and window dressing involved in reported earnings. Irrespective of whether a cash outlay is categorized as an operating expense in P&L, or capitalized into an asset on balance sheet, FCF is a true measure of the money left over for investors.
Besides explicitly considering the business drivers involved, DCF allows investors to incorporate key changes in the business strategy in the valuation model, which otherwise will go unreflected in other valuation models (like relative, APV, etc.)
While other methods like relative valuation are fairly easier to calculate, their reliability becomes questionable when the entire sector or market is over-valued or under-valued. DCF cuts across through this quandary and predicts the best possible instrinsic value.
Most importantly, DCF model can be used as a sanity check. Instead of estimating the fair intrinsic value, the current share price of the company can be plugged into the model, and working backwards, DCF model will tell how much the company’s stock is over-valued or under-valued, and also whether the current stock price is justified or not.
DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won’t be accurate.
It works best only when there is a high degree of confidence about future cash flows. But if the company’s operations lack visibility, it becomes difficult to predict sales, operating expenses and capital investment with certainty. While forecasting cash flows for the next few years is difficult, pushing them out perpetually (mandatory for DCF Valuation) becomes almost impossible. As such, DCF method is susceptible to error if not properly accounted for these inputs.
One major criticism of DCF is that the terminal value comprises far too much of the total value (65-75%). Even a minor variation in the assumptions on terminal year can have a significant impact on the final valuation.
DCF Valuation is an ever-changing target that demands constant vigilance and modification. If any expectations about the company change, the fair value will change accordingly.
DCF Model is not suited for short-term investing. Instead, it focuses on long-term value creation.