Valuation Challenge: 'The proper use of DCF'

Mel Abraham

THE CHALLENGE:
Fat Company, Inc. is a privately held concern that has been profitable since a year after its inception three years ago. During that three-year time period it has also experienced a high level of growth due to its relatively young age and the industry dynamics. In that regard, certain economic developments in the industry and the economy as a whole have given rise to some uncertainty in the stability of its operations. We Want Money, LP is a an investment fund that holds an interest in Fat Company, Inc. and has historically used the company's projections as a basis for calculating the cash flows to be used in a discounted cash flow model to determine the value of their interest.

Given the new developments and the uncertainty how do these facts impact (if at all) the ability to use discounted cash flows as a basis for valuing the interest in Fat Company, Inc.?

MEL ABRAHAM'S ANSWER:
Most transactions and deals are based on some measure of a cash-on-cash return. As such there are two primary components that need to be estimated: cash flows and the rate of return (cost of capital) to be used to discount the cash flows.

One of the standard problems that any DCF faces is the validity of the long term forecasts/projections. For this reason investors are forced to use short term forecasting as a primary tool. But the validity of the same is questionable. The mismatch between short term forecasts and cash flow generated out of long term assets is a primary problem for any seller/investor.

The estimate of the cost of capital that is an important aspect of the DCF model is a very challenging job. This estimate of rate of return is the rate of return an investor expects on their opportunity cost. Cost of capital includes cost of equity and cost of debt. Cost of equity is always more expensive than cost of debt. This is due to the risk involved with the invested capital. As there is no explicit method to estimate the cost of equity (in a privately held concern), because it is intrinsic to every investor, the ability of a DCF model to depict the true estimate of the cost of capital can be problematic if caution is not exercised. An error on this front would directly impact the decision on choosing to invest or not.

Given the current uncertain environment of the economy and industry it becomes important to capture this uncertainty in the combination of the forecasts used OR the cost of capital. I say “OR” because we have seen in some cases where folks have considered these factors in both places which in effect “double dips” the issue.

As a result, one possibility is to create multiple projected outcomes based upon the possible scenarios that could play out. Once these have been developed in detail and supported by the research and analysis, the projections can be probability-weighted based upon the likelihood of achieving them to come to a probability-weighted projection to be used in the final discounted cash flow analysis. This final probability-weighted projection would be discounted at a single cost of capital. The cost of capital would be a typical cost of capital for the industry in question since much of the risk is captured in the cash flows and the cash flows were subsequently probability weighted.

One thing for certain, in this environment it would not be business as usual and the forecasts used and the cost of capital used must be reconsidered to make sure that measure of value captures the risks perceived by the investor.