Valuation Challenge: A discourse on discounted cash flow

For December's Valuation Challenge, PJ Viscio, managing director for Duff & Phelps, looks at the fair value implications of discounted cash flow and market comparable approaches.

Limited Public Pension Fund (LPP) owns investments in a fund managed by General Private Partners (GPP) and a fund managed by General Equity Partners (GEP). Each fund has a 50 percent equity ownership interest in Portco Acquisition Company (Portco).

For the quarter ended 30 September 2008, GPP used a discounted cash flow (DCF) method to estimate the fair value of its fund's 50 percent Portco investment at $107 million. Meanwhile, GEP utilised a market comparable approach (multiple approach) and arrived at an estimated for its fund 50 percent Portco investment of $93 million.

What are the fair value implications of choosing one methodology versus another?

What factors may account for different fair value conclusions by GPP and GEP?

What are the implications, if any, for LPP?

The use of one methodology does not necessarily, if applied appropriately, result in valuation conclusions higher or lower than one that would be derived from the use of another methodology. When both a DCF and a market comparable analysis are used, the resulting values should not be inconsistent with each other.

When one sees a DCF value of 100 and value derived from a multiple approach of 50, there may be the temptation to split the difference. So, assuming a 50-50 weighting, the conclusion would be 75. However, when the indicated values are that far apart, it would be like having two watches where one reads noon and the other reads 6 pm, and then concluding that the time is actually 3 pm. This means that at least one watch has the wrong time and the 3 pm estimate is not particularly meaningful.

Private equity investors use an LBO model (essentially a modified DCF) to price deals going in. They take into account expected future cash flow (reflecting expected growth), timing, and risk/return (including cost of financing). A key component of the deal pricing is the calibration of the results of the LBO model with observed multiples in the market place. On a going-forward basis, the use of a DCF should, if possible, likewise be calibrated or at benchmarked to multiples observed in the market.

Market multiples can be thought of as benchmarks of risk and return. Within a comparable group (where there is comparable business risk), the key driver of the resulting multiple is expected growth, also a key driver of value indicated by a DCF. One may even think of a multiple approach as a shortcut DCF. When the results of a DCF and a multiple approach differ significantly, it indicates that the underlying assumptions, explicit or implicit, used in the two analyses are inconsistent with each other. For example, should the DCF value be significantly higher than the one indicated by a multiple approach, it may be the result of overly aggressive growth rate assumptions. Alternatively, if much better growth prospects relative to those of the comparable companies are real and supportable, then the application of a multiple within the observed range may be too low, and one above the observed range may be more appropriate.

If applied correctly, the use of different methodologies should not account for differing valuation between GPs. However, there are reasons as to why different GPs will ascribe different values to the same investment. Value, like beauty, is a perceptual phenomenon. It will be a function of the information available, and the assessment and interpretation of the information and resulting impact on future expectations.

There are instances where a fund holds a minority investment and thus may not have the same access to information and/or access to information at the same time as the controlling entity. Additionally, the assessment of that information, with respect to growth and risk may be different. For example, the assessment may be based on a different perspective of the prospects and risk of the sector than that of the other GP.

Limited partners are concerned about the fair value of their own LP interests, which in turn are driven by the expectations of the general partners reflected in the valuations. While the resulting valuations by different GPs may differ, the important things to keep in mind are (1) whether the valuations are reasonable and supportable and (2) whether they are directionally consistent. A material mark up by one general partner and a material mark down by another would be a severe disconnect and would indicate that the assumptions used by at least one of the GPs are highly questionable.