Why doesn’t your DCF analyses always provide the expected results?

BVWire–UKIssue #50-1
May 9, 2023

The authors of The Footnotes Analyst argue this month that models based on enterprise free cash flow should, in theory, produce the same result as invested capital models. Often they don’t. The application of growth factors in terminal value calculations is one of the major reasons DCF and “residual value” models can differ, they demonstrate in “DCF Version Residual Income: A Difference in Returns.” For example:

[A]ssume high historical investment by a company has resulted in low aggregate return, but this return is forecast to improve because the incremental return on new investment is expected to be much higher. The impact is that invested capital will grow at a lower rate than profit or cash flow and, as a consequence, residual income will grow at a higher rate.

Other factors can affect DCF calculations besides terminal growth rates, the authors demonstrate. They observe that “it is common to base valuations on adjusted rather than GAAP metrics. If income or expense items that are reflected in changes in balance sheet items are excluded from the profit used for residual income, the residual income based valuation will be incorrect.”

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