Why DCF Is Not Always the Best Valuation Method
Introduction
It is difficult to accurately assess the future growth potential of either type of company because its revenues will fluctuate greatly each year due to multiple factors outside the company's control (e.g., changes in consumer demand).
This makes it hard to get an accurate picture of an early stage or high growth company's worth based on DCF analysis; for instance, a start-up may have no historical cash flows to use as a reference point, but it may already have a customer base. As a result, analysts tend to rely more heavily on other types of analysis (e.g., comparable sales, market multiples, etc.) in order to determine an early stage company's value.
There are a number of other valuation methodologies that can provide more relevant and accurate assessments of a company's true worth than DCF analysis. In addition to traditional discounted cash flow analysis, there are also several different variations on the DCF methodology (e.g., adjusted present value). There are also numerous types of valuation models available today—some examples include asset-based, liquidation, sum-of-the-parts, and price-to earnings approaches.
Don’t Have A "Perfect" Model
Many investors also mistakenly believe that there is a "perfect" valuation model that can give them an accurate assessment of every company and any type of business. All models are simply approximations of the real world, based on idealized assumptions. If you want a model that can accurately depict the value of every single company, you’ll have to create your own. Each individual investor will ultimately have to develop a unique model based on their own perspective and experiences in investing, as well as the market trends that ultimately affect the specific industries/companies being evaluated.
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Startups, tech firms, and high-growth companies usually
have:
- Negative or inconsistent cash flows
- Rapidly changing business models
- Uncertain long-term profitability
For firms to project financials 5-10 years into the future, it becomes more of guesswork than an actual analytical exercise. Therefore, for these types of companies relative valuation (multiples) or venture type valuations typically provide a better source for decision-making purposes.
Terminal Value Makes Up A Large Portion Of The Valuation
The majority of a company's total value is generally found in the terminal value of a discounted cash flow (DCF) model, with as much as 60-80% of the value coming from this point.
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This indicates that the terminal value of a DCF model
relies heavily on:
- Terminal growth rate assumptions
- Exit multiples assumed for the year that all assumed success occurred.
If a large portion of a company's value is dependent on what will happen so far in the future, a discounted cash flow model will not necessarily reflect contemporary values that reflect the actual fundamentals, but instead reflect the long-term speculation of the market.
DCF Does Not Consider Market Sentiment Or The Pricing Of Comparable Companies
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Discounted cash flow valuation is an intrinsic valuation
model. Consequently, it does not factor in the following
factors:
- Market sentiment
- Industry Cycles
- Investor risk attitude regarding investments
- How comparable companies are priced
Though intrinsic values can provide meaningful insight, the actual market may choose to place or remove value from a company based on the comparison of other companies in the same industry. Therefore, it is possible for a company to have an undervalued DCF model when compared to its current trading value because peers are experiencing difficulties at this time. Professional institutional investors will rarely use the DCF alone to provide financial analysis compared to the DCF.
Difficult To Determine Value Of Companies Whose Assets Fluctuate With Cycles And Commodities
Forecasts are highly uncertain, as economic conditions develop at a different pace than companies, ultimately causing market conditions to change in varying degrees, and Management uses a different strategy than Valuation. That is why Valuation is based on Range and Probability – with a DCF Valuation we arrive at a point estimate.
For most companies, building a Detailed DCF is Time-Intensive and has little Incremental Additional Insight, meaning that 20% of the DCF process can provide 80% of the Insight into the Companies compared to Multiple Valuation methods combined with Qualitative Analysis.
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DCF is especially time-consuming when:
- There is little Information available
- The Analyst has time constraints to meet
- The Analyst must analyze multiple Companies in the Investment Universe
When the Business Model has Stable, Predictable Cash Flows, then DCF works best. When Long Term Estimations can be reliably estimated, then the DCF is even more valuable, especially when used in conjunction with Other Valuation Methods. Therefore, when using DCF Methodology, one must always use Other Valuation Methods in addition to DCF.
In summary, DCF is a powerful tool that should be used in conjunction with Proper Valuation Methodologies, especially when making Investments. Good Analysts know that Valuation Methodologies are All Approximate; the best Valuation is that which matches the Company being Valued.