Monday, February 23, 2015

DCF Myth 1: If you have a D(discount rate) and a CF (cash flow), you have a DCF!

Earlier this year, I started my series on discounted cash flow valuations (DCF) with a post that listed ten common myths in DCF and promised to do a post on each one over the course of the year. This is the first of that series and I will use it to challenge the widely held misconception that all you need to arrive at a DCF value is a D(iscount rate) and expected C(ash)F(lows). In this post, I will take a tour of what I would term twisted DCFs, where you have the appearance of a discounted cash flow valuation, without any of the consistency or philosophy.

The Consistency Tests for DCF

In my initial post on discounted cash flow valuation, I set up the single equation that underlies all of discounted cash flow valuation:


For this equation to deliver a reasonable estimate of value, it is imperative that it meets three consistency tests:

1. Unit consistency: A DCF first principle is that your cash flows have to defined in the same terms and unit as your discount rate. Specifically, this shows up in four tests:
  • Equity versus Business (Firm): If the cash flows are after debt payments (and thus cash flows to equity), the discount rate used has to reflect the return required by those equity investors (the cost of equity), given the perceived risk in their equity investments. If the cash flows are prior to debt payments (cash flows to the business or firm), the discount rate used has to be a weighted average of what your equity investors want and what your lenders (debt holders) demand or a cost of funding the entire business (cost of capital).
  • Pre-tax versus Post-tax: If your cash flows are pre-tax (post-tax), your discount rate has to be pre-tax (post-tax). It is worth noting that when valuing companies, we look at cash flows after corporate taxes and prior to personal taxes and discount rates are defined consistently. This gets tricky when valuing pass-through entities, which pay no taxes but are often required to pass through their income to investors who then get taxed at individual tax rates, and I looked at this question in my post on pass-through entities.
  • Nominal versus Real: If your cash flows are computed without incorporating inflation expectations, they are real cash flows and have to be discounted at a real discount rate. If your cash flows incorporate an expected inflation rate, your discount rate has to incorporate the same expected inflation rate.
  • Currency: If your cash flows are in a specific currency, your discount rate has to be in the same currency. Since currency is primarily a conduit for expected inflation, choosing a high inflation currency (say the Brazilian Reai) will give you a higher discount rate and higher expected growth and should leave value unchanged.
2. Input consistency: The value of a company is a function of three key components, its expected cash flows, the expected growth in these cash flows and the uncertainty you feel about whether these cash flows will be delivered. A discounted cash flow valuation requires assumptions about all three variables but for it to be defensible, the assumptions that you make about these variables have to be consistent with each other. The best way to illustrate this point is what I call the valuation triangle:


I am not suggesting that these relationships always have to hold, but when you do get an exception (high growth with low risk and low reinvestment), you are looking at an unusual company that requires justification and even in that company, there has to be consistency at some point in time.

3. Narrative consistency: In posts last year, I argued that a good valuation connected narrative to numbers. A good DCF valuation has to follow the same principles and the numbers have to be consistent with the story that you are telling about a company’s future and the story that you are telling has to be plausible, given the macroeconomic environment you are predicting, the market or markets that the company operates in and the competition it faces. 

The DCF Hall of Shame

Many of the DCFs that I see passed around in acquisition valuations, appraisal and accounting  don’t pass these consistency tests. In fact, at the risk of being labeled a DCF snob, I have taken to classifying these  defective DCFs into seven groups:
  1. The Chimera DCF: In mythology, a chimera is usually depicted as a lion, with the head of a goat arising from his back, and a tail that might end with a snake's head. A DCF valuation that mixes dollar cash flows with peso discount rates, nominal cash flows with real costs of capital and cash flows before debt payments with costs of equity is violating basic consistency rules and qualifies as a Chimera DCF. It is useless, no matter how much work went into estimating the cash flows and discount rates. While it is possible that these inconsistencies are the result of deliberate intent (where you are trying to justify an unjustifiable value), they are more often the result of sloppiness and too many analysts working on the same valuation, with division of labor run amok.
  2. The Dreamstate DCF: It is easy to build amazing companies on spreadsheets, making outlandish assumptions about growth and operating margins over time. With attribution to Elon
    Musk, I could take a small, money losing automobile company, forecast enough revenue
    growth to get its revenues to $350 billion in ten years (about $100 billion higher than  Toyota or Volkswagen, the largest automobile companies today), increase operating margins to 10% by the tenth year (giving it the margins of  premium auto makers) and make it a low risk, high growth company at that point (allowing it to trade at 20 times earnings at the end of year 10), all on a spreadsheet. Dreamstate DCFs are usually the result of a combination of hubris and static analysis, where you assume that you act correctly and no one else does.
  3. The Dissonant DCF: When assumptions about growth, risk and cash flows are not consistent with each other, with little or no explanation given for the mismatch, you have a DCF valuation
    where the assumptions are at war with each other and your valuation error will reflect the input
    dissonance. An analyst who assumes high growth with low risk and low reinvestment will get too high a value, and one who assumes low growth with high risk and high reinvestment will get too low a value.  I attributed dissonant DCFs to the natural tendency of analysts to focus on one variable at a time and tweak it, when in fact changes in one variable (say, growth) affect the other variables in your assessment. In addition, if you have a bias (towards a higher or lower value), you will find a variable to change that will deliver the result you want.
  4. The Trojan Horse (or Drag Queen) DCF: It is undeniable that the biggest number in a DCF is the terminal value, and for it to remain a DCF (a measure of intrinsic value), that number has to be estimated in one of two ways. The first is to assume that your cash flows will continue
    beyond the terminal year, growing at a constant rate forever (or for a finite period) and the second is to assume liquidation, with the liquidation proceeds representing your terminal value. There are many DCFs, though, where the terminal value is estimated by applying a multiple to the terminal year’s revenues, book value or earnings and that multiple (PE, EV/Sales, EV/EBITDA) comes from how comparable firms are being priced right now. Just as the Greeks used a wooden horse to smuggle soldiers into Troy, analysts are using the Trojan horse of expected cash flows (during the estimation period) to smuggle in a pricing. One reason analysts feel the urge to disguise their pricing as DCF valuations is a reluctance to admit that you are playing the pricing game.
  5. The Kabuki of For-show DCF: The last three decades have seen an explosion in valuations for legal and accounting purposes. Since neither the courts nor accounting rule writers have a clear
    sense of what they want as output from this process (and it has little to do with fair value), and there are generally no transactions that ride on the numbers (making them "show" valuations), you get checkbox or rule-driven valuation. In its most pristine form, these valuations are works of art, where analyst and rule maker (or court) go through the motions of valuation, with the intent of developing models that are legally or accounting-rule defensible rather than yielding reasonable values. Until we resolve the fundamental contradiction of asking practitioners to price assets, while also asking them to deliver DCF models that back the prices, we will see more and more Kabuki DCFs.
  6. The Robo DCF: In a Robo DCF, the analyst build a valuation almost entirely from the most recent financial statements and automated forecasts. In its most extreme form, every input in a
    Robo DCF can be traced to an external source, with equity risk premiums from Ibbotson or Duff and Phelps, betas from Bloomberg and cash flows from Factset, coming together in the model to deliver a value. Given that computers are much better followers of rigid and automated rules than human beings can, it is not surprising that many services have created their own versions of Robo DCFs to do intrinsic valuations. In fact, you could probably create an app for a smartphone or tablet that could do valuations for you. (I had originally listed Morningstar as a service that produced Robo DCFs but was alerted to the fact that it has substantial analyst input into its DCF.)
  7. The Mutant DCF: In its scariest form, a DCF can be just a collection of numbers where items have familiar names (free cash flow, cost of capital) but the analyst putting it together has
    neither a narrative holding the numbers together nor a sense of the basic principles of valuation. In the best case scenario, these valuations never see the light of day, as their creators abandon their misshapen creations, but in many cases, these valuations find their way into acquisition valuations, appraisals and portfolio management.
DCF Checklist
I see a lot of DCFs in the course of my work, from students, appraisers, analysts, bankers and companies. A surprisingly large number of the DCFs that I see take on one of these twisted forms and many of them have illustrious names attached to them. To help in identifying these twisted DCFs, I have developed a diagnostic sequence that is captured visually in this flowchart:



You are welcome to borrow, modify or adapt this flowchart to make it yours. If you prefer your flowchart in a more conventional question and answer format, you can use this checklist instead. So, take it for a spin on a DCF valuation, preferably someone else's, since it is so much easier to be judgmental about other people's work than yours. The tougher test is when you have to apply it on one of your own discounted cash flow valuations, but remember that the truth shall set you free!

  1. If you have a D(discount rate) and a CF (cash flow), you have a DCF.  
  2. A DCF is an exercise in modeling & number crunching. 
  3. You cannot do a DCF when there is too much uncertainty.
  4. The most critical input in a DCF is the discount rate and if you don’t believe in modern portfolio theory (or beta), you cannot use a DCF.
  5. If most of your value in a DCF comes from the terminal value, there is something wrong with your DCF.
  6. A DCF requires too many assumptions and can be manipulated to yield any value you want.
  7. A DCF cannot value brand name or other intangibles. 
  8. A DCF yields a conservative estimate of value. 
  9. If your DCF value changes significantly over time, there is either something wrong with your valuation.
  10. A DCF is an academic exercise.

10 comments:

Anonymous said...

Hi Professor,

In your post, you mentioned that "If your cash flows are in a specific currency, your discount rate has to be in the same currency", in which case, how would you determine an appropriate discount rate for a company that has significant amount of earnings offshore (such as MSFT or GSK), would you be looking at taking a weighted average of the WACC for each currency or use some other approach?

Thanks!

Hemanth Manda said...

Dr. Damodaran,
A quick question on your statement regarding currency consistency ...

"If your cash flows are in a specific currency, your discount rate has to be in the same currency"

Lets say the firm that I am valuing is in Brazil and sells 90% of its goods in Brazil and the rest 10% in US. Do I have a choice here in which currency I value the firm. i.e. Can I convert all future cash flows of the firm to USD and use an US WACC. If so, how do I account for currency fluctuations and the entailed risk? or should I be approaching this differently. Remember I used 90% - 10% as an example .. it could as well be 50% - 50%.

Appreciate your response.

- Hemanth

Aswath Damodaran said...

Almost every company gets its cash flows in multiple currencies. You have two choices. You can pick a currency and convert all cash flows into that currency, which will require that you use differential inflation to forecast exchange rates, and discount at a cost of capital in that currency. Alternatively, you can value each currency stream separately and add up the values at the end. That will require that you estimate costs of capital in all the local currencies. Pick your poison.

Anonymous said...

I recall reading about a research study done last year that found most sell-side analysts made errors using DCF and overvalued their companies by an average of 30%? It is too hard to do.

Aswath Damodaran said...

If you really believe that equity research analysts do DCFs, you probably also believe in the tooth fairy. I think you are talking about Trojan Horse DCFs, at best, and Mutant DCFs, at worst.

Anonymous said...

hi
are there insights by VALE results today?

rs55 said...

I dont include share buybacks as a legitimate item in "Cash Flow to Equity". If Iam a shareholder who does not sell into the buyback - I receive no cash. presumably at some point in the future I will receive larger dividends due to the reduced sharecount if any, after executive stock option exercises are netted out. So - back to dividends. I distrust any analysis that uses "cash flow to equity" rather than "Dividends" in performing a valuation exercise. For a large swath of businesses that dont pay dividends, then , the challenge is to figure out when they might do so. That is the only useful valuation exercise.

Anonymous said...

Dear Professor,
I guess what you are saying is that DCF valuation is more of an art than discipline. Having said that, your remarks about unit consistency are quite logical, however, the other two require significant judgement. Could you please share how to deal with those consistency checks from practical point of view? Which narrative is plausible, which growth rate is low or high relative to the assumed risk?

Thank you

Anonymous said...

Dear Sir, Correct me if I am wrong. For terminal value to be anything other than liquidation value we are implicitly assuming that the competitive advantage of the business will last for ever i.e. there will never be perfect competition in this industry which brings the return on capital to the same level as cost of capital..is that a correct assumption ?..Kind Rgds

Walid said...

How well does the concept pf "optimal debt equity combination" work (i.e. the financing principle) given that in real life it is the Banks that really dictate or insist on how much equity they want you to put up for your project before they approve and give you the Debt part?