A DCF (discounted cash flow) valuation is one of the most common valuation methods for both public and private businesses.. but its still not perfect.
Here’s the reason why, and some tips I use to sanity check the output of the DCF.
The benefit of the DCF method is that offers the most levers to think about business valuation.
This makes this method one of the most flexible and intuitive approaches.
But because of this flexibility, it can also easily introduce subjectivity and a broad range of valuation outcomes.
The reason is that the DCF approach can be quite powerful because it lets the valuation have a lot of assumptions.
And.. with great power comes great responsibility.
So here are some tips for how to validate the results of your DCF.
ASSUMPTIONS DURING THE FORECAST PERIOD
This includes both the top-line estimates as well as the costs and investment (Capex).
A common temptation that deal teams fall into, especially because of short deal timelines, is to have the deal team do the forecasts on behalf of the business.
Try to avoid this at all costs.
The business team knows the space typically much better than the deal team, and the business team is ultimately responsible for driving the results from the business.
So the deal team can “own the model” but the business team should own all assumptions about the forecast period, down to EBITDA and Cash Flow.
TERMINAL VALUE
Generally, the value embedded in the DCF after the forecast period sometimes accounts for nearly 50% – 60% (or even higher) of the value of the DCF.
Check the perpetuity growth rate (generally should be around the expected inflation rate and long-term economy growth rate) and develop sensitivities for a 2% – 5% range.
Also, calculate the implied enterprise value multiple of the terminal value (i.e. the value at the end of the forecast period) using the perpetuity growth rate method, and compare that multiple with trading EV / EBITDA multiples today to check for reasonableness.
DISCOUNT RATE
The recommended approach is to calculate the buyer’s WACC (cost of capital) as a starting point.
For most companies, the WACC ends up being in the 8% – 12% range.
You can also apply other factors to adjust the discount rate for company-specific risks (e.g. private company targets, which are more illiquid than public ones).
But most importantly, ensure that the discount rate methodology is applied apples to apples when evaluating targets.
Don’t use discount rates as the main “lever” to justify a higher valuation for a target.
ENTERPRISE VALUE
Finally, compare the resulting final Enterprise Value’s implied EBITDA multiple with where comparable companies are today.
If it’s really far off, it probably means that your DCF assumptions are either too bullish (more likely) or too bearish… then go back and work with the business team to build conviction in all the assumptions.
The above areas are not exhaustive but generally help develop a healthy sanity check for the output of the DCF.