Key Outcome of the Paper Common Errors in DCF Models by Michael Mauboussin. (Emphasis Ours)
First principles tell us the right way to value a business is to estimate the present value of the future cash flows. While most Wall Street professionals learned about discounted cash flow (DCF) models in school, in practice the models they build and rely on are deeply flawed.
- Forecast Horizon that is too short:
Forecast beyond a couple of years is suspect, therefore, investors use more certain, near term earnings forecasts. Such reasoning makes no sense, for at least two reasons. First, a key element in understanding a business’s attractiveness involves knowing the set of financial expectations the price represents.
The mismatch between a short forecast horizon and asset prices that reflect long-term cash flows leads to the second problem: investors have to compensate for the undersized horizon by adding value elsewhere in the model. The prime candidate for the value dump is the continuing, or terminal, value. The result is often a completely non-economic continuing value. This value misallocation leaves both parts of the model—the forecast period and continuing value estimate—next to useless.
We recommend explicit forecast periods of no less than five years, and note many companies require over ten years of value-creating cash flows to justify their stock prices. Ideally, the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance.
- Uneconomic Continuing Value:
The continuing value component of a DCF model captures the firm’s value for the time beyond the explicit forecast period, which can theoretically extend into perpetuity.
While developing a DCF model’s structure, investors must mind one of microeconomics’ most powerful lessons: competitive forces assure that return on investment will approximate the cost of capital over time
The crucial consequence of a too-short forecast period is the modeler has to heap the value burden on the continuing value estimate in order to have any consonance with the market price. As a consequence, the model fails to reflect a clear sense of the company’s pattern or timing of value creation.
In contrast, segregating the model into a period of value creation and value neutrality not only makes sound economic sense, but allows for greater model clarity. We can capture then continuing value with a perpetuity assumption, capitalizing the last year’s net operating profit after tax by the cost of capital. This value, even discounted to the present, often represents 60-70 percent of corporate value.
- Cost of Capital
The cost of capital is an estimate of the rate of return an investor demands to hold an asset or, said differently, an investor’s opportunity cost. As such, the cost of capital is the proper rate for discounting future cash flows to a present value.
Most companies finance their operations largely through debt and equity. The cost of debt, especially for large companies, is generally transparent because companies have contractual obligations to make coupon payments and return principal on a timely basis. Estimating the cost of equity is more challenging.
Unlike debt’s explicit cost, the cost of equity is implicit. The cost of equity is higher than the cost of debt because equity’s claim is junior. But no simple method exists to estimate the cost of equity. CAPM is the most common approach.
CAPM = RFR + Beta * ERP
Note: Government-issued notes generally provide a good proxy for the risk-free rate. Estimates for the equity risk premium and beta prove more challenging.
- Beta - Beta is wonderful theoretically but fails practically and empirically. The practical failure surrounds what beta to actually use in the CAPM. Ideally, we want forward-looking betas, which we cannot reliably estimate.
- Equity Risk Premium : Like beta, the equity risk premium is ideally a forward-looking estimate. Most analysts rely on past equity risk premiums, which, depending on the time frame, may not give a reasonable sense of the return outlook.
Most of the problems with the cost of capital come from stale inputs for beta and the equity risk premium. In addition, research suggests the equity risk premium is probably nonstationary, which means using past averages may be very misleading. Specifically, variables shaping the equity risk premium—like past stock returns, stock price volatility, and business conditions—clearly change, making it likely the ex-ante equity risk premium changes as well.
- Mismatch between assumed investment and earnings growth
DCF models commonly underestimate the investment necessary to achieve an assumed growth rate. This mistake often comes from two sources. First, analysts looking at companies that have been highly acquisitive in the past extrapolate an acquisition-enhanced growth rate while only reflecting capital spending and working capital needs for the current business. You can mitigate this error by carefully considering the growth likely to come from today’s business—which will be less than an acquisition-fueled rate.
The second reason for underestimating investment stems from a simple failure to explicitly link growth and investments via ROI.
- Improper Reflection of other liabilities
In the widely-used free cash flow to enterprise approach, an analyst determines the corporate value based on the present value of future cash flows. The analyst then adds cash and any other nonoperating assets and subtracts debt and any other liabilities to arrive at shareholder value. Most liabilities, including debt and many pension programs, are relatively straightforward to determine and reflect in the model. Some other liabilities, like employee stock options, are trickier to capture.
- Discount to private market value
A DCF model reflecting a public market discount must already incorporate synergies or some other catalyst for higher cash flows the company cannot achieve on its own. Modelling possible deal synergies is fine, though the exercise should remain separate from valuing the standalone business. The discount-to-private-market-value model lacks sufficient transparency because it conflates the base and synergy cash flows.
- Double Counting
Models should not count a dollar of value (or liability) more than once. Unwittingly, DCF models often double count the same source of value.
Probably the most-often-cited criticism of a DCF model is that small changes in assumptions can lead to large changes in the value. We addressed part of that concern, which can be mitigated by lengthening the forecast horizon, in our discussion of the first two errors.