Research to Improve Cash Flow Valuation Methods 20 Feb 2014

Research to Improve Cash Flow Valuation Methods

There are different approaches to valuing a business and some are better than others for each sector, but a valuation based on discounted cash flows (DCF) works for almost any business. While it is not perfect, it does establish a value for a business that may lack comps or is not easily valued with other approaches. The approach to constructing the analysis is well documented in texts and on finance websites, this article highlights concepts that are important but are not in focus in the texts.

There are some issues that need addressed for a DCF, first, finding the WACC, second, establishing the cash flows, and third, determining the approach and inputs for a terminal value. The criticism of a DCF is an analyst can tinker and arrive at the desired value to support a predetermined thesis. Debates center around an analysts WACC and terminal multiple selections too often and not enough around the actual cash flows. Market research enhances the DCF but is often ignored or not conducted comprehensively.

The weighted average cost of capital or discount rate is a simple enough calculation that brings in the cost of equity and the average cost of debt. While the debt side of the equation is straight forward, the equity portion is slightly more complicated. The key component is selecting the correct market risk based on the size of the company. Smaller companies have a greater risk premium than large ones.

In addition, the company and industry specific factors need accounted for in the discount rate. This part is more an art than a science. But it is also why a large cap, deep cyclical steel firm with a bad management team gets a higher discount rate than a large cap, consumer durable that is well managed. In the case of the deep cyclical, increase the discount rate for greater alpha risk as well as industry risk. The discount rate may come out to 10%, the analyst should increase/decrease the rate based on each factor. In this example, the well-managed company should have its rate reduced for that factor. Research into the company and industry should identify factors to account for here. It is possible to both add and subtract from the rate to account for risks associated with different factors, such as a good management team (positive), in a low margin, highly competitive business (negative) that has abnormally high debt (negative).

The cash flow projections are critical in what they add to the value and also how they impact the terminal multiple. Analysts often miss the projecting the sales and margins correctly. First, a full cycle needs forecast. For some industries, it is a 3-4 year cycle and for others that it’s a ten years cycle.  The forecast should match this. Second, margins and sales should vary over the cycle for a firm and all things are cyclical to some extent. A growth company is subject to the economic cycle which impacts sales and margins, so it needs accounted for in the forecasted cash flows.

Market research can help better determine the discount rate and the cash flow forecast. It can identify a company’s standing in an industry, key drivers, customer sentiment and other factors. For example, a company that is a premium brand deserves a lower discount rate than the discount brand. A research firm such as Research Optimus can help fill in these holes and uncover critical factors to the analysis that can get missed.

Last, arriving at the correct cash flow for the final year to apply the Gordon growth, exit multiple or other terminal valuation approach will also improve the accuracy of the analysis. In total, undertaking some basic market research to understand the company’s place within its industry and uncover factors that improve your forecast will improve the DCF analysis and the returns the investor generates over the long-term.

– Research Optimus

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