“I want to take you through the ten layers of hell,” Professor Aswath Damodaran of NYU Leonard N. Stern School of Business told a rapt general session on day two of the AICPA/ASA joint BV conference in Las Vegas.
Always an intelligent, insightful—and entertaining—speaker, Damodaran’s session on “Valuation Inferno: Dante Meets DCF” once again challenged valuation analysts to question their most common and deeply-held assumptions. “Let’s be honest, when you sit down [to do a valuation] you have a number in mind, and you spend the entire process trying to back into this number by playing with the growth rate,” he told attendees, citing just one element of the discounted cash flow (DCF) method that can earn some valuators a spot in their own special hell. “The terminal value is not an ATM,” he explains. “You cannot keep going and withdrawing cash any time you like.” In a similar vein, Damodaran questioned the ten elements and assumptions of the DCF that—while they may be hellish, can cause analysts some true heartburn:
- Current year numbers: “It’s amazing how wedded we are to that one-year, baseline number.”
- Cash flows. “You can’t stop forecasting cash flows until you’re willing to make an extraordinary assumption: that your cash flows are going to grow at a constant rate into perpetuity,” Damodaron told attendees. “It’s the tail that wags every valuation dog.”
- Taxes: Damodaron explains: “We double count some, add some, ignore some.”
- Growth. “We want all our businesses to grow, but ask the wrong people—the owners and managers—and you’ll get ‘30% growth rate for as far as the eye can see.” Don’t ever let the growth rate exceed the risk-free rate, he explains.
- Discount rate. “I think we spend far too much time talking about cost of equity, cost of capital, cost of debt—and not enough on cash flows.” Damodaran says. Analysts “outsource” so many of the elements of the calculation (to Ibbotson’s data, Bloomberg data, Duff & Phelps, etc.), “that it’s frightening.”
- Growth rate revisited. To grow a business, owners have to put money back into the business, and that’s a cost of growth analysts may overlook. Instead, the focus should be on the quality of the business’ growth.
- Debt ratio revisited. “We spend a lot of time trying to get the discount rate right,” Damodaran says. “But given your own assumptions about the company, you should expect the discount rage to change [over time].” Instead, “the discussion should be about the discount rates.”
- Garnishing valuations. The noted Professor confides that the only time he received hate mail was in response to a presentation, “Stop the Garnishing,” which challenged “add-ons” such as control premium, minority discounts. “The practice of garnishing defeats the entire point of the valuation,” he maintains. “It puts you back to…trying to get the number that you want and puts all of our biases into play.”
- Per-share value. An issue primarily for public company valuations, which questions the “easy” practice of determining per-share value by dividing the company’s market value by the number of shares—but often overlooks stock options, liquid/illiquid shares, etc.
- I-bankers inferno. The “darkest, deepest” layer of hell is reserved for those investment bankers who have forgotten the “purpose of a valuation,” and in pricing an M&A deal, will often pick the wrong company (the target company instead of the acquirer) and the wrong discount rate (cost of debt instead of cost of equity) to arrive at the number (fees) they want.
Professor Damodaran routinely posts his presentations at his website; a must-see for all BV experts. This one—with its extensive illustrations of the DCF inferno into which some analysts can fall, promises to be one of the more provocative.
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