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The DCF Model: Question Your Assumptions

By David Larrabee, CFA


Categories: Financial Statement Analysis, Portfolio Management, Quantitative Methods

Daily deal website operator Groupon (GRPN) recently sold shares to the public via a highly
anticipated IPO and saw its stock surge more than 30% on its first day of trading. Earlier this
year, social networking company LinkedIn (LNKD) saw its shares more than double on its first
day of trading. Though the share prices of both firms have since retreated to trade well below
their post-IPO peaks, these public debuts of companies showing great revenue growth but little
to no earnings were reminiscent of the dot-com bubble of the late 1990s, and there is a natural
temptation to get caught up in the hype. For this reason, it is as important as ever for analysts to
rely on the fundamental principles of investing and valuation. And the discounted cash flow
(DCF) model is a great place to start.
DCF analysis is one of the most reliable of analytical tools, and when applied to equity valuation,
it derives the fair market value of common stock as the present value of its expected future cash
flows. While the DCF model arguably provides the best estimate of a stocks intrinsic value, it
also relies on a number of forward-looking assumptions that analysts need to consider carefully.
As the saying goes, Garbage in, garbage out. CFA charterholder Gregrory A. Gilberts
timeless overview of the DCF model underscores this message and reminds us of some of the
potential pitfalls associated with this valuation approach.
Professor Aswath Damodaran from the Stern School of Business at New York University, a
prolific author and noted authority on valuation matters, addresses the sensitivities of the DCF
model in much of his work, including this brief interview. And his presentation titled Valuation

Inferno: Dante Meets DCF Avoiding Common Mistakes in Valuation Analysis is a step-bystep dissection of traditional DCF analysis wherein he guides the audience through the process of
calculating a more accurate estimate of fair market value. With hyperbole, Damodaran invokes
the 14th-century poet Dante Alighieri to describe the hellish challenge analysts often face in
DCF valuation. He focuses on several critical component variables of the DCF model in which
analysts are most prone to misstep and offers an alternative route. Some of Damodarans
suggestions include:

Dont overestimate growth. Analysts are generally too optimistic when it comes
to estimating firm growth rates. Success begets competition, which invariably leads
to slower growth. Professor Andrew Metrick, from the Yale School of
Management, introduced a model for forecasting a young companys growth in his
book Venture Capital and the Finance of Innovation and found that start-ups
usually revert to an industry average growth rate within five years.
Avoid regression betas. Regression betas, commonly used in calculating the cost
of equity, generally have large standard errors. Betas should reflect the business the
firm operates in, its operating leverage, and its debt level. Damodaran calls for the
use of sector betas as a way to eliminate the noise that comes with regression betas
calculated on individual firms.
Dont calculate terminal values using relative multiples. The terminal value, or
the value of the firm at the end of a cash flow projection period, has a great impact
on the present value calculation. Unfortunately, analysts often simply apply a
multiple relative to a peer group, turning what should be an intrinsic valuation into
a relative valuation. Instead, use a stable growth dividend discount model like the
Gordon growth model to estimate the terminal value.
Use long-term risk-free rates. Rather than simply plugging in a short-term riskfree rate, as many analysts do, the term of the risk-free rate should approximate the
term of the expected cash flows. In most cases, this means using the long-term
government bond as the risk-free rate.

Depending on their underlying inputs, fair value estimates based on DCF modeling can
vary significantly, making it clear that analysts using the DCF model would be well
served to consider the validity of the assumptions they are making.
For those interested, Damodaran has posted his DCF analysis of GRPN and LNKD on his
blog.

Valuation 101: How to do a discounted


cashflow analysis
Sunday, Jan 22 2012 by Stockopedia Features
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What is a DCF Valuation?


Discounted cash flow (DCF) analysis is a method of valuing the intrinsic value of a company (or
asset). In simple terms, discounted cash flow tries to work out the value today, based on
projections of all of the cash that it could make available to investors in the future. It is described
as "discounted" cash flow because of the principle of "time value of money" (i.e. cash in the
future is worth less than cash today).
The advantage of DCF analysis is that it produces the closest thing to an intrinsic stock value relative valuation metrics such as price-earnings (P/E) or EV/EBITDA ratios aren't very useful if
an entire sector or market is overvalued. In addition, the DCF method is forward-looking and
depends more on future expectations than historical results. The method is also based on free
cash flow (FCF), which is less subject to manipulatio than some other figures and ratios
calculated out of the income statement or balance sheet.
DCF does however have its weaknesses as an approach. As it is a mechanical valuation tool, it is
subject to the principle of "garbage in, garbage out". In particular, small changes in inputs can
result in large changes in the value of a company, given the need to project cash-flow to infinity.
James Montier argues that, "while the algebra of DCF is simple, neat and compelling, the
implementation becomes a minefield of problems" (he cites, in particular, problems with
estimating cash flows and estimating discount rates). Despite the issues, DCF analysis is very
widely used and is perhaps the primary valuation tool amongst the financial analyst community.
As part of Stockopedia Premium, we provide pre-baked DCF valuation models for all stocks,
which you can then modify with your own assumptions.

So how does it work?


In summary, the key steps in a DCF analysis are as follows:
1.
2.
3.
4.
5.

Estimate Cashflows
Estimate Growth Profile (1 stage, 2 stage, 3 stage etc) & Growth Rates
Calculate Discount Rate
Calculate the Terminal Value
Calculate fair value of company and its equity

We explain each of these steps in more detail below.

1. How do we estimate base cashflow for a DCF?


In a DCF model, the first step is to estimate how much cash that the business will generate and
could be paid to the investors. In the strictest sense, the only cash flow that an investor will
receive from an equity investment is the dividend. Actual dividends, however, may be much
lower than the potential dividends because i) managers are conservative and like to hold on to
cash to meet unforeseen future contingencies and investment opportunities. When actual
dividends are less than potential dividends, using a model that focuses only on dividends will
understate the true value of the equity in a firm. Some analysts assume that the earnings of a firm
represent its potential dividends but this will typically over estimate the value of the equity in the
firm. Earnings are not cash flows, since there are both non-cash revenues and expenses in the
earnings calculation. This also fails to take into account the need for a firm to invest in new
assets in order to grow.
For that reason, the best option is to focus on free cash flow - there are two main such
definitions:
i) Free Cash Flow to the Firm (FCFF). This is the cash available to bond holders and stock
holders after all expense and investments have taken place. It is defined as:
EBIT * ( 1 - tax rate) - (Capital Expenditures - Depreciation) - Change in Working Capital.
ii) Free Cash Flow to the Equity (FCFE). This is the cash is available to pay to a company's
equity shareholders after accounting for all expenses, reinvestment, and debt repayment. It is
defined as:
Net Income - (Capital Expenditures - Depreciation) - Changes in non-cash Working Capital (Principal Repayments - New Debt Issues) OR alternatively Cash From Operations - (Capital
Expenditures - Depreciation) + Net Borrowing.
If we are looking to value the equity, then the most obvious option is to use FCFE. FCFF is
preferred if the company is unstable or has huge amount of debt because the FCFE might be very
low or negative in this case. Basically, the drawback of FCFE is that it will change if the capital
structure changes. That is, FCFE will go up if the company replaces debt with equity (an action
that reduces interest paid and therefore increases CFO) and vice versa.

2. How do we forecast a company's cash-flow growth profile?


The next step is to estimate how fast will the company grow its free cash flow. This is a critical
part of any valuation and is typically where the biggest errors creep in. People tend to
overestimate how fast a company can grow. First, we need to decide whether how many different
stages of growth the DCF will have. A 1 stage DCF model would be used for a company
expected to see consistent stable growth. The prevalent form of the DCF model in practice is the
two-stage DCF model - this involves an explicit projection of free cash flows generally for 5-10

years, following which a terminal terminal value is calculated to account for all the cash flows
beyond the forecast period - but a more involved 3+ stage DCF model could also be used.
Once this is decided, there are three basic ways of estimating growth for any firm:
i) Extrapolate from historic growth - One option is to use historic growth rates, but
unfortunately these rates tend to have considerable noise associated with them. In an study of the
relationship between past growth rates and future growth rates, Little (1960) coined the term
'Higgledy Piggledy Growth" because he found little evidence that firms that grew fast in one
period continued to grow fast in the next period. In addition, measurement is not straightforward
- growth rates can be different depending the period selected or they may be complicated by the
presence of negative earnings.
ii) Trust the Analysts - The second approach is to trust the equity research analysts that follow
the firm to come up with the right estimate of growth for the firm, and to use that growth rate in
valuation. However, the evidence suggests that analysts are very poor forecasters, especially over
the long-term. Work by James Montier found that the average 24-month forecast error is around
94%, and the average 12-month forecast error is around 45%.
iii) Fundamental Determinants - With both historical and analyst estimates, growth is treated
as an exogenous variable that affects value but is divorced from the operating details of the
firm. As Professor Damodaran notes, the alternative way of incorporating growth into value is to
make it endogenous, i.e., to make it a function of how much a firm reinvests for future growth
and the quality of its reinvestment. When a firm has a stable return on capital, its expected
growth in operating income (and therefore cashflow) is a product of the reinvestment rate, i.e.,
the proportion of the after-tax operating income that is invested in net capital expenditures and
non-cash working capital, and the quality of these reinvestments, measured as the return on the
capital invested. The formula is:
Reinvestment Rate * Return on Capital where Reinvestment Rate = Capital Expenditure Depreciation + Change in Non-cash WC and Return on Capital = EBIT (1-t) / Capital Invested
Option iii) is probably the best option but may feel a bit involved. A simpler approach would be
to look at historic growth over the past several years, take an average, and then reduce that in
stages. A three-stage model might take the last 3-years' growth rate, apply it to the next five
years, chop it in half for the next five years, and then reduce it to 3% (the long term rate of
inflation, e.g. no "real" growth) from then on.
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3. How do we choose a discount rate?


Having projected the company's free cash flow for the next X years, we need an appropriate
discount rate which we can use to calculate the net present value (NPV) of the cash flows. This is
a critical ingredient in discounted cashflow valuation. Errors in estimating the discount rate or
mismatching cashflows and discount rates can lead to serious errors in valuation. It is important

that the Discount Rate should be consistent with the cash flow being discounted. If the cash
flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity.
If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital (or
WACC - the weighted average cost of capital).
Cost of Equity

Equity shareholders expect to obtain a certain return on their equity investment in a company.
From the company's perspective, the equity holders' required rate of return is a cost. However,
unlike the cost of debt which is relatively easy to determine from observation of interest rates in
the capital markets, a company's current cost of equity is unobservable and must be estimated.
CAPM

There are various models for doing so, the most commonly accepted of which is the Capital
Asset Pricing Model, or CAPM where:
Cost of Equity (Re) = Risk Free Rate (Rf) + Beta * Equity Risk Premium.
To explain these terms:
i) Risk-Free Rate - This is the amount obtained from investing in securities considered free from
credit risk, such as US government bonds.
ii) - Beta - This measures how much a company's share price moves against the market as a
whole. A beta of one, for instance, indicates that the company moves in line with the market. If
the beta is in excess of one, the share is amplifying the market's movements; less than one means
the share is more stable.
iii) Equity Market Risk Premium - The equity market risk premium represents the returns
investors expect, over and above the risk-free rate, to compensate them for taking extra risk by
investing in the stock market. In other words, it is the difference between the risk-free rate and
the market rate. Practitioners never seem to agree on the premium; it is sensitive to how far back
you go in history, what bonds you use as a reference point, and whether you use geometric or
arithmetic averages.
While widely used, CAPM has been widely criticised as being empirically flawed - according to
Montier, "CAPM woefully under predicts the returns to low beta stocks, and massively
overestimates the returns to high beta stocks. Over the long run there has been essentially no
relationship between beta and return" - as well as being based on a highly unrealistic set of
assumptions. For that reason, it may be better to just adopt a discount rate that seems intuitively
consistent with both the riskiness and the type of cashflow being discounted.
Interestingly, Buffett uses something like the thirty-year U.S. treasury bond rate but without a
risk premium on the basis that he avoids risks. "I put a heavy weight on certainty. If you do that,
the whole idea of a risk factor doesn't make any sense to me. Risk comes from not knowing what

you're doing." (although, presumably, as a value investor, he builds a significant margin of safety
elsewhere).

4. How do we calculate the Terminal Value?


Instead of trying to project the cash flows to infinity, terminal value techniques are used. One
way of calculating the terminal value (TV) is by using the Gordon Growth Model, which
essentially assumes that company's cash flow will stabilize after last projected year and will
continue at the same rate forever. Here is the formula:
Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate) / (Discount Rate
Long-Term Cash Flow Growth Rate).
Another possibility of determining terminal value of the company is to use multipliers of income
or cash flow measures (net income, net operating profit, EBITDA, operating cash flow or FCF),
which are determined with reference to comparable companies on the market.
The TV often represents a large percentage of the total DCF valuation. As Montier notes:
"If we assume a perpetual growth rate of 5% and a cost of capital of 9% then the terminal
multiple is 25x. However, if we are off by one percent on either or both of our inputs, then the
terminal multiple can range from 16x to 50x!".
Valuation, in such cases, can unfortunately become largely dependent on TV assumptions rather
than operating assumptions for the business or the asset.

Calculate Fair Value of Company & Equity


To arrive at a total company value, or enterprise value (EV), we simply have to take the present
value of the cash flows and the Terminal value, divide them by the discount rate and, finally, add
up the results. If we are discounting FCFE at the cost of equity, this will give the value of the
equity. If we are discounting FCFF at the weighted average cost of capital, this would give the
value of the firm, so it would be necessary to deduct net debt in order to arrive at the equity
value.

Conclusions
Although Montier argues that DCF "should be consigned to the dustbin of theory, alongside the
efficient markets hypothesis, and CAPM", this seem a little harsh. It is a useful tool, provided that
its constraints are clearly understood (e.g. the sensitivity to inputs), and it is best used with other
tools such as Earnings Power Value and Relative Value techniques as a sense check. In order to
use DCF most effectively, the target company should generally have positive and predictable
free cash flows (i.e. typically it's best with mature firms that are past the growth stages). DCF
works less well when a company's operations lack "visibility" - i.e, when it's difficult to predict
revenue and cost trends with much certainty. DCF analysis also demands vigilance so if

Company X delivers disappointing quarterly results, or if interest rates change dramatically, you
may need to adjust your assumptions.
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