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Demystifying Discounted Cash Flow Analysis in Valuations

By Mandeep Trivedi, Ashi Nafiu .

Professional services organizations like Citrin Cooperman regularly consult with clients who own privately-held businesses with the goal of ascertaining the fair value of the clients’ private investments. The discounted cash flow (DCF) analysis, which involves determining the value of a business by converting anticipated economic benefits into a current, present value, is one of the widely-used methods of estimating the value of investments and a companies’ worth under the income approach. Despite its prevalence, DCF is often shrouded in myths, misinterpretations, and misapplications that can lead to inaccurate valuations and misguided decision making.

Myths surrounding the DCF method

One of the most widespread misconceptions is the belief that a DCF provides exact valuations. Many users assume that the method yields precise and definitive results, not realizing that a DCF is fundamentally based on assumptions and projections that can vary significantly. The accuracy of a DCF valuation relies heavily on the reliability of projected cash flows and the chosen discount rate, making it an estimate rather than an exact figure. Consequently, it is subject to considerable uncertainty that requires the sound judgement of a professional.

Another common myth is that a DCF is suitable for all companies. While the DCF method can be broadly applied, it is most effective for companies with stable, predictable cash flows. It is less suitable for startups, high-growth companies, or businesses in volatile industries where future cash flows are uncertain and difficult to forecast. Using DCF in such contexts can lead to misleading valuations.

Misinterpretations in the analysis

A significant misinterpretation involves the terminal value, which often constitutes a large component of the DCF valuation and can account for upwards of three-quarters of the valuation. Some analysts mistakenly consider the terminal value as the most critical element, overemphasizing its importance. While the terminal value is indeed significant, overreliance on it can overshadow the importance of accurately projecting near-term cash flows. Without realistic long-term growth assumptions, a high (or low) terminal value can distort the overall valuation.

Another common misinterpretation is the confusion between free cash flow to equity (FCFE) and free cash flow to the firm (FCFF) and the appropriate discount rate to apply in each case. Some analysts erroneously equate the two, failing to recognize that the discount rate in DCF using the FCFF is typically the weighted average cost of capital (WACC), while discount rate in DCF using the FCFE is typically the cost of equity. The discount rate reflects the riskiness of the business and includes a risk premium over the risk-free rate to account for the uncertainty of future cash flows. Properly distinguishing between these cash flows and relevant discount rates is crucial for accurate DCF analysis.

Misapplications of DCF

In practice, analysts sometimes misapply DCF by ignoring or improperly applying or calculating changes in working capital and capital expenditures. These items significantly impact free cash flow and thus the valuation. Neglecting these changes can result in an inflated valuation, as it does not accurately reflect the cash available to the company. Proper DCF analysis must incorporate changes in working capital and capital expenditures to provide a realistic estimate of free cash flow.

Another common misapplication is the use of static growth rates throughout the discrete projection period. Applying a constant growth rate can misrepresent a company’s growth prospects, failing to account for different lifecycle stages. A more nuanced approach involves using higher growth rates in the initial years and tapering off as the company matures which involves having careful discussion with management on the stage of the company’s growth and direction. This may provide a more realistic and accurate valuation.

The importance of involving a professional in DCF analysis

The DCF approach is often misunderstood and misapplied, leading to misconceptions such as the belief that it provides precise valuations and is universally applicable. Common misinterpretations include an overemphasis on terminal value and confusion on the appropriate discount rate to use in the model. Additionally, misapplications like confusing cashflow to equity with cashflow to the firm, ignoring changes in working capital, and applying static growth rates can result in inaccurate valuations, highlighting the need for careful and informed use of DCF analysis. In essence, it is better to consult with an experienced professional that can leverage DCF analysis to provide valuable insights and more accurate valuations.

If you have questions about DCF analysis or a valuation for your privately-held businesses, please reach out to Ashi Nafiu at anafiu@citrincooperman.com or Valuation Advisory Services Practice Managing Partner Mandeep Trivedi.

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