Andrew Greta's Business Development Blog

Discounted cash flow (or DCF) is one of the cornerstones of modern finance. The theory is simple. Discount a series of future cash flows at an interest rate that accounts for the risk-impacted time value of money and we can directly compare the net present value (or NPV) of multiple projects on an apples-to-apples basis regardless of variations or choppiness in their individual cash flow profiles.

C = Cash Flow
t = Time Period
r = Discount Rate

Used properly the NPV can provide objective and powerful insight into the projected dollar value created by an investment (as opposed to simply its percentage return) which can help corporate leaders make good value-creating (or destruction-avoiding) economic decisions. Used recklessly, “curve-fit”, bastardized DCF models spun up by I-bankers and corporate financiers alike have been used to justify all manner of wildly unrealistic valuations in the name of aggressive deal-making.

To see how it’s possible to corrupt such a seemingly pure financial principle, we need to dissect the equation and examine the primary variables to see how even small manipulations or faulty assumptions can yield wildly different NPVs based on the same underlying facts.

Drinking the Cash Flow Kool-Aid

Let’s say we’re considering buying business that makes Frammitz Valves and has the following historic cash flows:

Without digging into the business fundamentals, your average desktop finance jock sees a pretty substantial growth trajectory. Cash flows doubled between year 3 and 4, and had a more modest, but still impressive, 50% growth between year 4 and 5. Being a “responsible” finance practitioner, they might haircut that growth rate to 35%, forecast it out and voila! We get a chart that looks something like this:

Eagerly, they run off to report their findings to management and recommend paying up to $10,000 for the business and accompanying 5-year cash flows since that more than clears an assumed 20% cost of capital.

Unfortunately, what our hapless modeler failed to realize that while Frammitz Valves were a new and innovative product a few years ago, the market has been largely saturated and future revenues will likely slow considerably to and simply service the current demand at a maintenance level.

What looked like a positive NPV project at $10,000 ends up destroying over $5,000 of value because they failed to do the hard work it takes to understand the underlying business fundamentals.

WACCy Discount Rates

Theoretically speaking, the weighted average cost of capital (or WACC) represents the minimum return required by investors as a blend of both debt (interest payments) and equity (shareholder returns) financing. In practical terms, WACC is the “hurdle-rate” that informs investors whether an opportunity will provide adequate compensation for a given level of risk considering other investment alternatives available.

Because changes in WACC (or discount rate) dramatically affect the results of our DCF equation, it’s the subject of ridiculous shenanigans in the finance community. You can’t afford to pay $5,000 for those cash-flows at a 20% hurdle rate? Well, maybe those cash flows aren’t quite as risky as we thought. Let’s just trim that down to 18% and wow – suddenly we’re NPV positive! I’ve even seen discount rate “sensitivity” tables calculated out to the 100^th decimal place as if you can precision-bomb an anthill from lunar orbit.

At my alma mater, GE, WACCs were pegged at 14% corporate-wide, full stop. While maybe not theoretically rigorous from an academic perspective, the policy served a useful purpose by neutralizing the “creative finance” crowd and allowing apples-to-apples evaluations of opportunities based on a consistent metric across the board.

And truth be told, if you’re clearing a hurdle rate by mere millimeters and tweaking the dials by fractions of a hair to justify a razor-thin valuation, it’s probably time to kill the deal, move on, and look for an investment you can vault over with several feet to spare while hungover and wearing lead shoes.

Terminal Disease

In our Frammitz example above, we considered cash flows and NPV for a 5-year investment. But isn’t it reasonable to assume the business will survive longer? And if so, how do we take into account those future cash flows without extending out to an infinitely long Excel model?

One stupid-simple approach is to slap a “terminal value” on to the end of the forecast which is supposed to account for all future cash flows into eternity. One of the most widely abused and corrupted methods is the “growing perpetuity”.

According to this approach, the present value of an infinitely growing stream of cash is simply the initial cash flow divided by the difference between the discount rate and growth rate:

In other words, if I expect a $2,000 year-5 cash flow to grow at say 10%, by using by 20% discount rate, the value of that perpetuity is $20,000 ($2,000 / 0.10). Is that figure too low? No problem, just tweak the growth rate to 12% and holy explosive growth! I show $25,000 instead for a 20% bump in my valuation estimate. And who can argue? How the heck does anyone really know at what rate the business is going to grow at for eternity?

Which is the whole point of this folly. Businesses don’t operate forever (does anyone remember one time Dow Jones Industrial Average components Standard Rope & Twine Company or U.S. Leather?). Nor are cash flow growth rates consistent and predictable.

Reality Dose

DCFs can be an important addition to a valuation toolkit providing an objective viewpoint on true economic value creation – but only if used with reasonable care. Remember the basics:

• A DCF model is only as good as the cash flows forecast. Take some time and do the hard work to understand the business fundamentals before forecasting out historic growth rates like a blind chimpanzee with a crayon.
• Use a consistent WACC across projects. If you find yourself tweaking a discount rate to justify an investment, you’re better off looking for something more comfortably profitable at a reasonable hurdle.
• Avoid growing perpetuities in the terminal value calculation. One rule of thumb is that terminal values should never be more than 60% of total present value. Another method is to use an exit metric consistent with your entry philosophy and make a reasonable assumption about what price you could sell the business for in year 5.

Labels: Valuation