Our most recent online survey explored the more debatable aspects of the DCF, such as the treatment of cash, depreciation and capex, and marketability discounts. In a final question, we asked respondents to name any additional, unsettled areas of the analysis.
“Where to begin,” says one. The terminal growth rate, for example: If inflation is 2%, then how can the terminal growth rate be anything less? If global GDP is 6%, how can your terminal rate be any more? “It can’t,” this participant insists, “yet we see appraisals with such growth rates.” Similarly, some BV analysts use minority cash flows and don’t use a minority discount; some use controlling cash flows and then take the discount, or, when valuing a controlling interest in a company with different classes of stock, some appraisers ignore the preferred holders and assume industry weights when calculating WACC. “I’m sure the list could go on.”
In fact, survey comments provided the following (but not final) list of debatable DCF mechanics:
- “I wish people would stop including the option pool in their OPMs when the equity value is based only on outstanding securities.”
- Loan guarantees do not affect valuation; however, “we all know that if one partner pledges personal assets against some debt, the distribution of equity shouldn’t be 50/50. This should receive more attention in the valuation community.”
- “Which size premia to use—10v, 10a, 10b.”
- WACC: which tax rate to use, which interest rate, and what weightings to use for debt and equity.
- “All aspects of the cost of equity estimate—even the appropriate risk-free rate.”
- “In almost all DCF valuations I have seen, there is never even an attempt to make sure that in the terminal value assumption, the return on invested capital is equal to WACC.”
- The length of the projection horizon: “There is no rule that says it has to be five years. Theoretically, the time horizon could be cut off as soon as you can incorporate a steady growth assumption.”
- “Gordon Growth vs. EBITDA multiples in the terminal value and the relevance of EBITDA reasonableness checks in high-risk, high-growth companies.”
- Tax affecting pass-through entity cash flows for non-tax-related engagements, such as divorce, shareholder disputes, etc.
“Everything is unsettled in the courts!” another participant believes, particularly in Daubert cases, when poor expert testimony may lead a court to reject even “settled” DCF assumptions. At that same time, another respondent believes: “The only things that are unsettled are by … judges who do not understand valuation or by academics who always try to reinvent the wheel with things that nobody who buys real companies does.” Bottom line: The debate on the DCF will continue in the valuation community and the courts. Is there any particular “unsettled” aspect of the analysis you’d like us to survey in-depth? Please email the editor.
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