Wednesday, January 23, 2013

Estimating value: Part 1 An Overview of Discounted Cash Flow

Previously, we've written that Value is estimated, Price is paid.  Today we  start to discuss some of the many ways to estimate value.  Each method has advantages and disadvantages.  None is perfect but taken together they provide a meaningful framework for estimating value.

Some of the major techniques used to estimate value include:

  • Discounted cash flow
  • Multiples
  • Comparable Transactions

In today's post, I'll provide an overview of discounted cash flow, returning to multiples and comparable transactions at a later time.  We'll also ignore liquidation value and book value for this post.  Liquidation value is useful when you are anticipating dismantling a company and book value is, well, historic.  The book value of any asset doesn't necessarily reflect true value and is often dramatically different.  That said, there seems to be some  information in book value.  Multiples of book value, for example, are often used in valuation.

True or intrinsic value

So we mentioned 'true value'.  It is often called 'intrinsic' value, and yes, it exists in the eye of the estimator.  The true worth of an asset, of course, is what someone else will pay for it.  But in valuing our company this is unknown.  How can we get estimates of intrinsic value, estimates that inform a meaningful selling price?

DCF in practice

Let's start with discounted cash flow.  Simply put, the value of any business asset is the stream of cash flows it will generate throughout its life, expressed in today's dollars.  We generally assume that businesses, and the equity that represents ownership in these businesses have an infinite life.  Products follow a life cycle.  Companies that produce them can last indefinitely by continuing to adapt, replacing old products with new ones.  Now, we can't meaningfully think about cash flows at year seventeen, let alone at infinity so we often use a shorter term investment horizon.  Let's take five years and assume (probably artificially) that we sell the company or stock at the end of this period.  Whether we do is immaterial, it just helps us conceptualize the issue.

So in the diagram below we have two cash flow streams, one stretching to infinity and one truncated at five years.   The present value of each of these streams is the current worth of the company.

The equation describing the discounting process (converting the cash flows into today's values) is shown below.

Terminal value
Note that in the arrowed diagram and in the equation the cash flows stretching from year six to infinity are replaced by SP5, the terminal value.  This is the assumed selling price in year 5.  How do we estimate this selling price?   Two standard techniques are: a) a constant growth model and b) price multiples.  The first technique is a mathematical reduction of assuming cash flows will grow at a constant rate forever.  The second is based on the valuations of related companies.  Both methods have some merit.  I'll cover multiples in a separate post, but let me address an often voiced concern with assuming 'constant growth'.  Sure, no company is likely to actually have constant growth, but as we noted above, it becomes impossible to estimate growth precisely at some date in the future.  What is your estimate of growth in year 17 ??  Our choice is to either ignore the future or incorporate our best guess.  Constant growth does the latter.  Also, commonly used multiples (of earnings, book value, etc) have built-in but unstated assumptions just as heroic.  A word of caution: probably 70-90 percent of a firms value will occur after year five.  Be very  careful with that estimate.  

Advantages and disadvantages of DCF
An advantage of the discounted cash flow technique is that it can be applied to any business from purchasing a motel in Orlando to a photography store in Crested Butte to purchasing General Motors. In each of these examples, the value of the business to the owners is equal to the present value of all the distributions the business will generate. 
It is sometimes argued that discounted cash flow is difficult to understand.  To the contrary, the mechanics are easily applied using spreadsheets or financial calculators.  The intuition behind discounting is also easy to understand: money received in the future is worth less than money received today. The intuition behind the rate we use is also straightforward: We should discount cash flows at the appropriate opportunity cost. In other words, evaluate this project at the rate we could earn on projects of similar risk.  Our answer to the question: “What rate could we earn elsewhere with the money at this risk level?” answers the rate question.  And since higher discount rates (associated with riskier ventures) lower the present value this method adjusts for risks.

It is also asserted that the DCF method requires too many assumptions.  It is true that forecasting the amounts received in the future and estimating the opportunity cost of funds require challenging assumptions.  Nevertheless, all valuation methods utilize assumptions.  With some techniques, however, the assumptions are hidden in the apparent simplicity of the process.  As a consequence, users are often making implicit assumptions without even being aware of it.  A major advantage of discounted cash flow is that the assumptions can be quite explicit.  The ability to fine tune projections of cash flows to recognize individual firm characteristics is a tremendous advantage. Moreover, most alternatives to discounted cash flow, such as using ad hoc rules of thumb to value an asset, do not allow for easy updating. Rules of thumb that held in the past may quickly become obsolete if some underlying factor of the economy (e.g. inflation) changes. Discounted cash flow with its component parts expressed in a spreadsheet allows for immediate revisions.

In a subsequent post, we'll take a brief look at multiples and comparables.

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