DCF and the future of corporate valuation

July 2017 | EXPERT BRIEFING | FINANCE & ACCOUNTING

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Business enterprise valuations are the foundation of investment analysis and banking, commercial lending, as well as financial accounting and bankruptcy reorganisation. At the core of contemporary valuation is the discounted cash flow (DCF) method. DCF’s acceptability is founded on economic theory, as well as practice.

Impressive lineage

Aptly titled, DCF is a means to value an enterprise by taking its free cashflow, discounting that cash to the present to account for timing of receipt. In practice, this present worth of the expected future cash from an enterprise is considered the truest measure of that value. DCF came into general use in finance and investment analysis in the 1970s and 1980s. This followed the introduction of the capital asset pricing model (CAPM), which afforded a rigorous means to quantify discount rates, as well as broadening the availability of computers to facilitate calculations. Since the 1980s, DCF has gained proponents with recommendations in texts on finance and investment, as well as commentary and case law. Examples include treatises by Federal bankruptcy justices and Chancery Court opinions.

A not so stable foundation

That said, after nearly 50 years, DCF’s reliability is increasingly being questioned based on changing perspectives regarding some of the same economic principles that explain its wide acceptance. These challenges go beyond theory to include DCF’s applicability. Implications for the practice of corporate valuation are significant. These concerns can be summed up in three related categories: changing views on how market values are set, the efficiency of markets and the role of judgement.

Three strikes

Traditional economic theory holds that investment decisionmaking is perfectly rational. That is, price and value are based solely on supply and demand and decisions driven by quantifiable determination of return. These concepts are losing credibility as the iconoclastic study of irrational decisionmaking on markets, referred to as ‘behavioural economics’, gains adherents. Reflected in the popularity of such books as Daniel Kahneman’s ‘Thinking Fast and Slow’, this theory postulates that value is driven by a multitude of factors, many of which cannot be prescribed by analyses premised on purely rational decisionmaking. This divergence from classical economics strikes at the utility of such quantitative methods as DCF.

Second, formulaic analyses such as DCF implicitly assume efficient markets and prices equating to value. However, there is a growing appreciation that markets can be inefficient and pricing of securities are of questionable relevance in valuation. For example, investors often make imperfect decisions due to timing, lack of information, misinformation, market manipulation, transaction expenses or sheer complexity. Such inefficiencies affect the security prices of companies deemed comparable in valuation, potentially tainting key inputs to a DCF.

Third is the related issue of the impact of subjectivity and bias on quantitative methods in general and DCF in particular. There are myriad judgements required in support of inputs underpinning valuation. Concerns over the affect of these judgements range from the derivation of the components of the weighted average cost of capital (WACC), to selection of projections which are certain to change, and assumptions made and techniques selected for the terminal year estimates which usually drive total value.

Valuing storytime

Taken together, these shifting perceptions of markets and the questionable application of quantitative methods challenge the efficacy of DCF. Addressing this credibility gap is a recent, thought-provoking book by Professor Aswath Damodaran at New York University’s Stern School, ‘Narrative and Numbers, the Value of Stories in Business’. In his latest text on valuation, Professor Damodaran confronts the inherent tensions between quantitative and qualitative analysis. He presents a series of company valuations to explicitly link into DCF qualitative ‘stories’, reflecting essential competitive features and outlooks for each business. A result is to incorporate key principles of behavioural economics and develop a more robust approach to DCF.

Related to possible market inefficiency, the author expands on his earlier treatises and acknowledges shortcomings in methods such as DCF. These include data overload, tendencies towards manipulation of analyses and a lack of precision. Offsetting these, valuation case studies provide a rigorous application of DCF and include such ‘story’ credits as Amazon, Uber and Alibaba. Major drivers taken into consideration include prospects for growth, changing market share, margins, reinvestment, capitalisation and cost of capital. By varying key assumptions underlying these cases and representing different views of each company’s business model, a story’s impact on value is clear. The qualitative viewpoints and applications illustrated by these case studies integrate a well-founded narrative business story into the quantitative framework of DCF.

What follows from these discussions is a resounding endorsement of DCF as the basis for gauging intrinsic enterprise value. The author buttresses his position by elaborating on prior work and dismissing traditional valuation methods based on comparability. Typically relied upon as alternatives to DCF, he argues that comparable company analysis addresses only the price of a security of a company deemed comparable and is of little use in the valuation of a business.

Back to the future of DCF

Reflecting the tension between quantitative and qualitative analysis magnified by the ascendency of behavioural economics, Professor Damodaran’s recent work encourages increased reliance on DCF. This holds the potential for a sea change in valuation practice. Dependent on projections and growth rates, future valuations should be more directly based on a company’s story. Consistent with that narrative, it remains the case that key assumptions reflect judgements easily overlooked or obfuscated in DCF. However, the rigor and thoughtful manner in which theorems and case studies are applied by the author should foster a higher level of confidence in DCF. The state of the valuation art is advanced and the potential applications of DCF increased. Expect ‘Narrative and Numbers’ to have as significant an impact over time on corporate valuation practice as earlier contributions of this penetrating and prolific authority.

Anders J. Maxwell is a partner and managing director at Peter J Solomon Company. He can be contacted on +1 (212) 508 1683 or by email: amaxwell@pjsc.com.

Anders J. Maxwell

Peter J Solomon Company