Top 3 Pitfalls Of Discounted Cash Flow Analysis

September 22 2010| Filed Under Cash Flow, Equity Valuation, Financial Statements, Financial Theory, Free Cash Flow, Income Statement Most finance courses espouse the gospel of discounted cash flow (DCF) analysis as the preferred valuation methodology for all cash flow generating assets. In theory (and in college final examinations), this technique works great. In practice, DCF can be difficult to apply in the valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are useful to help generate a complete valuation picture of a stock. (For more background, read Taking Stock Of Discounted Cash Flow .)

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Basics of DCF Analysis DCF theory holds that the value of all cash flow generating assets - from fixed-income to investments to an entire company - is the present value of the expected cash flow stream given some appropriatediscount rate. The formula for this is usually given something like this:

PV = CF1 / (1+k) + CF2 / (1+k)2 + [TCF / (k - g)] / (1+k)n-1

Where:

PV = present value CFi = cash flow in year i k = discount rate TCF = the terminal year cash flow g = growth rate assumption in perpetuity beyond terminal year n = the number of periods in the valuation model including the terminal year

For equity valuation, analysts most often use some form of free cash flow for the valuation model cash flows. FCF is usually calculated as operating cash flow less capital expenditures. Note that the PV has to be divided by the current number of shares outstanding to arrive at a per share valuation. Sometimes analysts will use an adjusted unlevered free cash flow to calculate a present value of cash flows to all firm stakeholders. They will then subtract the current value of claims senior to equity to calculate the equity DCF value and arrive at an equity value. (For more insight, read Taking Stock Of Discounted Cash Flow and Discounted Cash Flow Analysis.) Problems with DCF

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1.

Operating Cash Flow Projections The first and most important factor in calculating the DCF value of a stock is estimating the series of operating cash flow projections. There are a number of inherent problems with earnings and cash flow forecasting that can generate problems with DCF analysis. 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 "out" years of the model can be total shots in the dark. Analysts may have a good idea of what operating cash flow will be for the current year and the following year, but beyond that, the ability to project earnings and cash flow diminishes rapidly. To make matters worse, cash flow projections in any given year will most likely be based largely on results for the preceding years. Small, erroneous assumptions in the first couple years of a model can amplify variances in operating cash flow projections in the later years of the model. (To learn more, check out Style Matters In Financial Modeling .)

2.

Capital Expenditure Projections Free cash flow projection involves projecting capital expenditures for each model year. Again, the degree of uncertainty increases with each additional year in the model. Capital expenditures can be largely discretionary; in a down year, a company's management may rein in capital expenditure plans (the inverse may also be true). Capital expenditure assumptions are, therefore, usually quite risky. While there are a number of techniques to calculate capital expenditures, such as using fixed asset turnover ratios or even a percentage of revenues method, small changes in model assumptions can widely affect the result of the DCF calculation.

3.

Discount Rate and Growth Rate Perhaps the most contentious assumptions in a DCF model are the discount rate and growth rate assumptions. There are many ways to approach the discount rate in an equity DCF model. Analysts might use the Markowitzian R = Rf + (Rm - Rf) or maybe the weighted average cost of capital of the firm as the discount rate in the DCF model. Both approaches are quite theoretical and may not work well in real world investing applications. Other investors may choose to use an arbitrary standard hurdle rate to evaluate all equity investments. In this way, all investments are evaluated against each other on the same footing. When choosing a method to estimate the discount rate, there are typically no surefire (or easy) answers. (For more on calculating the discount rate, see Investors Need A Good WACC.)

Perhaps the biggest problem with growth rate assumptions is when they are used as a perpetual growth rate assumption. Assuming that anything will hold in perpetuity is highly theoretical. Many analysts contend that all going concern companies mature in such a way that their sustainable growth rates will gravitate toward the long-term rate of economic growth in the long run. It is therefore common to see a long-term growth rate assumption of around 4%, based on the longterm track record of economic growth in the United States. In addition, a company's growth rate

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will change, sometimes dramatically, from year to year or even decade to decade. Seldom does a growth rate gravitate to a mature company growth rate and then sit there forever.

Due to the nature of DCF calculation, the method is extremely sensitive to small changes in the discount rate and the growth rate assumption. For example, assume that an analyst projects company X's free cash flow as follows:

In this case, given standard DCF methodology, a 12% discount rate and a 4% terminal growth rate generates a per-share valuation of $12.73. Changing only the discount rate to 10% and leaving all other variables the same, the value is $16.21. That's a 27% change based on a 200 basis pointchange in the discount rate.

Alternative Methodologies Even if one believes that DCF is the be-all and end-all in assessing the value of an equity investment, it is very useful to supplement the approach with multiple-based target price approaches. If you are going to project income and cash flows, it is easy to use the supplementary approaches. It is important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on the company's history and its sector. Choosing a target multiple range is where it gets tricky.

While this is analogous to arbitrary discount rate selection, by using a trailing earnings number two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer assumptions to "value" the stock than under the DCF scenario. This improves the reliability of the conclusion relative to the DCF approach. Because we know what a company's P/E or price/cash flow multiple is after every trade, we have a lot of historical data from which to assess the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical and we do not really have any historical data to draw from when calculating it.

Be Open Minded As an investor, it's wise to avoid being too reliant on one method over another when assessing the value of stocks. While most investors probably agree that the value of a stock is related to the present value of the future stream of free cash flow, the DCF approach can be difficult to apply in real-world scenarios. Supplementing the approach with multiple based target price approaches is useful in developing a full understanding of the value of a stock.

Discounted Cash Flow - DCF

Filed Under Cash Flow, Equity Valuation, Value Investing

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Definition of 'Discounted Cash Flow - DCF'

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (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. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Calculated as:

Also known as the Discounted Cash Flows Model.

Investopedia explains 'Discounted Cash Flow - DCF'

There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. Despite the complexity of the calculations involved, the purpose of DCF analysis is just to estimate the money you'd receive from an investment and to adjust for the time value of money. Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

Net Debt To EBITDA Ratio

Filed Under Accounting, Financial Leverage

Definition of 'Net Debt To EBITDA Ratio'

A measurement of leverage, calculated as a company's interest-bearing liabilities minus cash or cash equivalents, divided by its EBITDA. The net debt to EBITDA ratio is a debt ratio that shows how many years it would take for a company to pay back its debt if net debt and EBITDA are held constant. If a company has more cash than debt, the ratio can be negative.

Investopedia explains 'Net Debt To EBITDA Ratio'

The net debt to EBITDA ratio is popular with analysts because it takes into account a company's ability to decrease its debt. Ratios higher than 4 or 5 typically set off alarm bells because this indicates that a company is less likely to

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be able to handle its debt burden, and thus is less likely to be able to take on the additional debt required to grow the business. Ultimately, however, it depends on the benchmark of the industry you are looking at.

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