Last week’s post addresses the complex relationship between intrinsic value and the market risk premium. It begins with the premise, often cited by equity investors, that a DCF will derive “intrinsic” value while valuation multiples derive only “relative” value.
Since many users of business valuation reports frown on DCF analysis, this belief presents particular challenges when trying to achieve IVS-mandated objectivity standards. Does a market data-based conclusion of value derive a price, or a value? Relative to what standard? How much should it then be discounted for willing buyer, willing seller standards?
Fortunately, Steve Cooper (who worked at IASB) and Dennis Jullens, the authors, have an answer that is quite supportive of the business valuation profession:
[T]his view is not only simplistic—both DCF and valuation multiples can be used in a so-called absolute and relative sense—but it can be incorrect.… All equity values, including those presented in financial statements, are measured relative to either current or historical market prices.
To prove their point, they cite the practice (by investors or particularly private equity buyers hoping to close their next deal) of “reverse DCF”:
Simply construct a DCF model based on your best estimate of all input assumptions and then flex one of these assumptions so that the DCF value equals the current stock price.
As usual, this latest post includes an interactive model regarding target enterprise value multiples. The model is a great way to show that, as Cooper and Jullens say, “the target multiples in the model are based on the same value drivers used in the DCF, except without the detailed explicit forecast used in a typical DCF” analysis.
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