Even the ‘settled’ aspects of DCF analysis … aren’t

BVWireIssue #121-4
October 24, 2012

The vast majority—nearly 92%—of respondents to last week’s survey on DCF inputs and assumptions typically maintain the same weighted average cost of capital throughout the forecasting period. A mere 8% adjust the WACC for market, company-specific, or other risks. So the BV community has largely settled that aspect of the analysis, right? In their comments, many respondents qualified their “yes” in these ways:

  • “I would consider changing it for a company that is either a start-up and/or in expansion mode,” writes one respondent.
  • “In more and more cases, the risk in the terminal [value] may be adjusted for the uncertainty of maintaining that level of profitability into perpetuity,” says another, who might also adjust the risk for anticipated “spikes” during the projection period.
  • If the company does not have the capacity to maintain a constant WACC and/or a minority interest is at stake, “we typically use an equity return rather than a WACC, [adjusted] to reflect reduced risk associated with lack of leverage.”
  • “There are times when debt is expected to be paid off or unique risks are present.”

And yet—“It is folly and academic nonsense to think that one could adjust WACC at different points for different risks,” says another respondent. “No buyers in the real world do this.” Another agrees, but for a slightly different reason: “A valuation is as of a point in time, and the WACC should reflect the facts and circumstances as of the valuation date.” But what if changing circumstances are known (or knowable) as of the valuation date? “Every situation is unique,” says another commentator, and analysts may apply a changing WACC if they “expect the company’s risk or leverage to change over the forecast period.”

“It is not clear,” says a final respondent. “There is a good argument for both sides.”

As there is for every question. In the same way, a strong majority of survey respondents—nearly 83%—add only cash in excess of working capital back into their DCF, but the comments also reveal the “yes, but … ” or “it depends” disclaimers. By contrast, other aspects of the DCF are clearly unsettled, such as whether to apply a marketability discount to a controlling interest and how to adjust for officer compensation. Predictably, the company-specific risk premium still generates wide debate, as does any presumption that depreciation should equal capex in the terminal year. We’ll highlight these issues next week, and Rod Burkert (Burkert Valuation) will provide a complete analysis for the Business Valuation Update. Given the liveliness of the discussion, we’ve kept the online survey open; to add your views, click here now.

Please let us know if you have any comments about this article or enhancements you would like to see.