Valuation methods: DCF model

The DCF model, also known as the cash flow model, may seem extremely complicated, danger-prone and a valuation tool only used by professionals if you are not familiar with it and listen to hearsay. Although the DCF model undoubtedly has these characteristics, when properly constructed, it is more understandable than its reputation and with its variations the most useful method for determining the real value of the business and its range.

Considering the above-mentioned dubiosity it makes sense to start with a short theory when summarizing the DCF model and dismantling possible related myths.

Which DCF model is right?

According to financial theory, the value of an individual asset is equal to the present value of free cash flows it generates during its life expectancy. Cash flow is a tangible good generated by the business. Without it, it would be impossible to pay salaries, obtain raw materials, buy necessary capital goods, meet the demands of the financiers or reward owners. In practice, cash flow is a valid currency of exchange and value creation, whereas the accounting result does not have such characteristics. In addition, the accrual-based accounting result is clearly a more discretionary item than cash flow because of different accounting practices.  

In short, the DCF model is a tool that allows the future cash flows generated by the business to be moved to the present day. Moving cash flows, i.e., discounting cash flow in official terms (DCF = Discounted Cash Flow), is based on the time value of money. In other words, on the idea that a euro in hand today, is more valuable than money of the same nominal value that you earn in one or two years. Future cash flows are moved to the present with a return requirement (discount factor) that reflects the business risk and balance sheet profile.

What are the cash flows in the DCF model?

The DCF model can be built either on free cash flow (FCFF = Free Cash Flow to First) or shareholders’ free cash flow (FCFE = Free Cash Flow to Equity).

When the model is built on the company’s free cash flow, the starting point is operational performance and as an interim outcome the debt-free value of the business (EV). After deducting the net debt or adding the net cash, the actual outcome is the fair value of the company. As an equation, the company's free cash flow looks as follows.

NOPAT is the result including operational taxes, i.e. an indicator measuring the company's operational efficiency and thus its performance. If the company has generated an operating margin of 10% with a EUR 150 million revenue last year and its operational tax rate is 20%, NOPAT is EUR 12 million. Depreciation is the amortized cost of previously made investments and gross investments cover all cash-flow investments made during the financial year. What is essential to understand about the nature of gross investment is that an invested euro does not know whether it has been put, e.g., into a new production line, a factory or acquired business. This means that gross investments also include acquisitions and are, therefore, not separately adjusted or added items.

Net working capital describes the current ongoing capital requirements of the business and, slightly simplified, it consists of the net amount of inventories, trade receivables and accounts payables. The main factors that affect the need for net working capital are, e.g., the business model and thus the strategic choices made (e.g. value chain position) and the structure of the industry. As business grows and net working capital is positive, the company has to invest in its cash flow to secure its supply and service ability. Considering this, actions that increase net working capital always include both tactical and strategic (i.e. focusing on customer relations) elements.

If, on the other hand, net working capital is negative due to, e.g., a front-loaded earnings model, the working capital required for revenue growth is fully financed by customers. When revenue decreases, the dynamics related to net working capital, and thus financing needs or financiers, are obviously the opposite.

A model based on shareholders' free cash flow in turn starts with the net profit that is adjusted for items that do not and do affect cash flow. The outcome of this approach is the fair value of the business attributable to shareholders, i.e. the value of the share capital. Similarly, the required return is merely the cost of equity in the case of the company’s free cash flow as it is the average cost of capital (WACC).

Broken down into components shareholders’ free cash flow is: net profit + depreciation – gross investments – change in net working capital + change in interest-bearing debt.

On a practical level, the last element in the equation reflects the pecking order of equity investors relative to their debt counterparts, because before profit is distributed to shareholders, the company must take care of its debt liabilities. Although the increase in debt capital technically raises the free cash flow attributable to shareholders, this does not have an equally straightforward effect on the fair value of the share capital. This is because all other things being equal and solvency decreases, the company's risk level and cost of equity will increase, i.e. the increased cash flow is moved to the present at a higher required return than before.

Although the free cash flows attributable to the company and the shareholders differ slightly both in their composition and required returns, they are exactly similar when it comes to valuation. Thus, correctly constructed models based on these cash flows with parameters based on the same factors (e.g. in the WACC of FCCF, the COE requirement is the same as in FCFE) and the same estimates should end up at the same conclusions.

From the estimate period to the terminal value

As the underlying idea and operating logic of the cash flow model is to move future cash flows to the present, it is not surprising that the starting point for building the model is to estimate the future of the business.

As an independent exercise, business forecasting is a comprehensive process and I believe that success requires you to assess and identify the hard core, i.e. the income flows, cost items and capital needs, made and upcoming strategic choices and competitiveness, as well as possible sources of advantages.

However, to understand the outcome of the cash flow model and, in fact, the usefulness of the entire model, one of the topics related to forecasting deserves separate consideration. This is the terminal value (TV) and its definition.

Typically, the cash flow model includes detailed estimates for a horizon of 5-10 years depending on the evaluator and their needs. The actual life cycle of the business, and in particular a high quality one, is considerably longer than this period, which means that cash flows after the exact estimate period must be assessed through a factor called the terminal value. From the perspective of the company’s free cash flow the terminal value can be shown as an equation.

In this composition, as mentioned before, NOPAT is the operating profit considering taxes on a cash flow basis, RI (reinvestment rate) is the investment need considering changes in net working capital and fixed capital investments, WACC is the average cost of capital, and g the expected sustainable EBIT growth (not revenue growth).

Since the long-term investment need is the ratio of expected sustainable operational earnings growth to the capital return/reallocation ability (g/ROIC or RONIC), it is clear that the assessment of the return on (re)invested capital is relevant for the determination of the terminal value. I think that two points should be emphasized here: 1) return on invested capital that is clearly and sustainably above the cost of capital in the long term requires a sustainable structural competitive advantage, which I believe is challenging to create in competitive industries to say the least; and 2) if the business is structurally weak and the return on capital is below the cost of capital, operational earnings growth destroys value, the company should focus on improving the quality of business instead of seeking growth. Considering this, the return on invested capital applied when calculating the terminal value should, for most companies, be significantly close to the estimated cost of capital.

Another trick related to the terminal value or more precisely its interpretation is related to its relative share of the company’s current value. If the company's business development is in an early stage and free cash flows in the next few years are negative, either due to low performance or heavy investments relative to the business size, the share of the terminal value in the current value of the business is typically very high . If turned into subjective and therefore rather clumsy heuristic, this could, e.g., mean a slice of over 70%. As the relative share of the terminal value is high, even minor changes in the components used to determine it – such as the growth rate or the estimated sustainable ROIC – can fluctuate the present value of the company heavily.

I feel that the high share of the terminal value can also be approached through assessing the quality of the decision-making process and a safety margin. The further in the future the cash flows generated by the business (i.e. estimated) are, the longer it takes to verify the underlying estimates and decisions made based on them. In reverse this requires a greater patience from the user of the model than a situation painted by the cash flows repatriated in a more easily foreseeable future while reducing the built-in safety margin (tools include conservatism in assessing the estimates and required return) against both undesirable and potentially permanent negative surprises.

Valuation is art rather than science

Although the DCF model is a good tool for determining the real value of the business and its range in terms of the technology and the underlying theory, it is not in any way an instrument for determining an exact value due to its nature of multiple variables and best guesses made by people based on information available at the time of assessment.

Therefore, I believe building the DCF model and interpreting the outcome it produces is more of an applied art than hard science.  I do not, however, see this as a problem for an independent thinker. Based on my observations, a civilized valuator understands that focusing on the right things and cause-and-effect relationships helps to be right enough and, correspondingly, to avoid being completely wrong.