ARTICLE FROM THE QUEENS BAR BULLETIN, FEBRUARY 2016

By: Joshua S. Sechter, CPA/ABV, CFE

The Discounted Cash Flow Method

The Discounted Cash Flow Method (“DCF”) is our profession’s more common alternative income approach to the simpler Capitalized Cash Flow Method (“CCF”) heavily used in the business valuation industry.[1]  While this method is the subject of much abuse and hopes of good fortune one should be very careful in exercising its use as it is easily open to attack.  At the same time, a well-built DCF model with all the right support can be just what you need to bring the opposing side to the negotiating table.

One of the main differences between the DCF and CCF is that the CCF method capitalizes a single period of cash flows into perpetuity.  A DCF capitalizes several periods of cash flows over a set time period into the future and may or may not be followed by a capitalization of terminal cash flows into perpetuity thereafter.  A common reason for using a DCF is that the user wants to capture the Company’s impact on its cash flows over the next five, ten, fifteen, twenty years, etc.

There may be a manufacturing plant expansion which will become operational in a few years which could have a significant impact on the value of the Company today.  A new service may be offered by your company which may generate additional levels of cash flow subsequent to your date of value.  A significant natural disaster may have occurred around your date of value for which the effects are still yet unknown. Any time you have uncertainty in your cash flows and you can project them with definitive level of accuracy a DCF can be designed to capture such effects and could be utilized.  However, my experience is that DCFs are not always applied with intelligent forethought.

Wide-spread and Rampant Abuse of the DCF

It is mind-boggling to me that I have assisted in the rebuttal for the use of DCF’s by out-spouse valuation experts who have created their own projections based on historical observations without any reliance on a forecast or projection or management’s opinion.  In one example I have seen flat revenues, no reason to expect significant growth, industry reports estimate three percent growth over the next five years and yet a DCF projection is created calling for five percent growth plus one additional growth percentage point each period for the next five years followed by four percent on the terminal period into perpetuity.  “Some analysts will use a growth rate into perpetuity that exceeds the nominal growth rate for the GDP of the United States.  If that assumption is made, at some point in time in the future…the Company’s value will be greater than the GDP of the United States.”[2]  While every case has its own facts we should not be blatantly misusing valuation models to create a false reality just to feed client expectations.  I am sounding the alarm bell, please stop, you are doing a dis-service to your clients, the courts and more importantly, our profession.

How radical is your DCF?

GROWTH

Anything higher than six percent growth in your terminal calculation is paramount to raw speculation in most circumstances.  “The growth rate is … intended to reflect a long-term average growth rate.  This long-term growth rate is also intended to be the average growth rate into perpetuity.  Over the past 80 years or so, inflation and gross domestic product have each grown on average approximately 2.5 to 3.0 percent and 3.0 to 3.5 percent, respectively.”[3]  So please use exercise and caution when applying your growth rate in your DCF model.

PROJECTIONS

Usually, unless the appraiser has expertise in a specific industry, projections are prepared by management of the subject company or a third-party industry expert is hired to prepare such projections.  When you are the out-spouse expert and you prepare your own projections for the subject company without speaking to management or considering the contents of the preceding sentence you are creating an imaginative fantasy of illusion.  In other words, you are eating your own words.  When using wildly optimistic projections prepared by management one should consider the use of a third party industry expert to tame them back to reality.  However, most of the time this doesn’t happen or isn’t cost-feasible which warrants more discussion.

REVENUES AS A KEY VARIABLE

When preparing a DCF the expert is making future assumptions about various key variables of the subject company such as revenues.  All other things being equal, when one has become aware that revenues over a historical five year period are flat and/or declining this should not be an indication that revenues will increase by millions of dollars each year into the future without substantive support to the contrary.  While projections prepared by management can be very useful one must be cognizant of the historical events which have taken place.  At a minimum you must consider these key factors when projecting increased revenues over your discrete periods and in your terminal calculation.

1. The increased workforce necessary to support the growth in revenues;
2. The increased rent, facility, and other fixed costs to facilitate that growth in revenues;
3. The increased working capital requirements to facilitate the growth in revenues;
4. The likelihood that the increased levels of revenues will be achieved.

Truth versus Reality

While our profession requires the pervasive use of subjectivity at its core, one should not abuse it to the point of blatant fallacy.  At the same time, at first glance a DCF may appear drastic until you discover the underlying details which support it.  The point is, make sure you support your model with as much facts as possible and document your assumptions in detail.  If you don’t heed this advice you may stray farther and farther from the truth without realizing it, leaving yourself wildly open to attack.

[1] Each of these methods attempt to determine the value of a Company by measuring the economic benefits of a future cash flow stream.

[2] Hitchner, James R., (2011). Financial Valuation – Applications and Models. Page 1252: John Wiley & Sons, Inc.

[3] Hitchner, James R., (2011). Financial Valuation – Applications and Models. Page 141: John Wiley & Sons, Inc.