November 23, 2018 WelchGroup

To DCF or not to DCF: That is the Question

The discounted cash flow (DCF) method is a widely adopted methodology for the valuation of public and private companies in Canada. The following blog article explores how this methodology, as well as other valuation methodologies, are applied in practice and whether certain methodologies are more appropriate than others for differing valuation purposes. In particular, we explore why certain methodologies, and not the DCF, appear to be more common in the areas of tax valuations, matrimonial and commercial litigation, and whether this promotes more accurate and reliable business valuations.

A Background on the DCF

The DCF was born from finance theory. Following the stock market crash of 1929, DCF analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book The Theory of Interest and John Burr Williams’s 1938 text The Theory of Investment Value first formally expressed the DCF method in modern economic terms.

The DCF has been widely adopted by corporate financial professionals, venture capitalists, private equity, angel investors, real estate investors, investment banking firms, and corporate acquirers. These finance professionals prefer to use the DCF (or derivatives thereof) for the valuation of private companies for investment, financings, acquisitions and IPOs.

Although there are critics of the DCF, this methodology appears to be widely used for some of the following reasons:

  1. The DCF provides better visibility on changes (year over year) of a company’s expected performance in terms of revenues, profitability and cash flow;
  2. The DCF allows investors/acquirers to stress test the assumptions on revenue, costs, working capital or capital expenditures, thus allowing for a better understanding of the risk and return relationship of a particular company;
  3. The DCF is not bound by market multiples, which may not be relevant or available for a private company. In addition, “multiple risk” is eliminated which is the reality that multiples can fluctuate over time, and sometimes widely, without any correlation to the company’s actual or expected performance;
  4. The DCF facilitates the inclusion of acquirer synergies in their valuation/pricing analysis, where most other methodologies do not; and
  5. The DCF can provide a baseline for measuring actual performance against projected performance, especially where the DCF used for a transaction is adopted as the operating budget post-close.

Given all of the above advantages, why do we see the prevalence of other valuation approaches, particularly in the areas of tax valuations (e.g., share restructuring, estate freezes, rollovers, etc.), and matrimonial and commercial litigation? We explore this further in the following section.

The Other Approaches

Some of the more commonly used valuation methodologies we encounter today include the following:

  1. The Capitalized Earnings or Capitalized Cash Flow methods; and
  2. The Market Approach (also called the Guideline Public Company Method or the Guideline Company Transactions Method).

[Note to reader: Have purposely excluded Asset Approaches and Rules of Thumb from this blog article as they only apply in very specific situations, which are outside the scope of this article]

The Capitalized Earnings (CE) or Capitalized Cash Flow (CCF) methods are derivations from the Dividend Discount Model (DDM), which determines the valuation of a company based on one identical earnings or cash flow level, often growing at a constant growth rate into perpetuity.

In other words, the CE/CCF methodologies assume that the company’s earnings or cash flow will be the same each year forever, without any significant expansion or contraction over time. This methodology does not allow for fluctuating growth (or high growth periods) in revenue, nor fluctuating profitability levels over time. In addition, the CE/CCF assumes that working capital and capital expenditures are constant into perpetuity, which is rarely the case in practice.

However, the CE/CCF methodologies are very widely used in tax valuations, matrimonial and commercial litigation. We believe that some of the reasons for this are as follows:

  1. The CE/CCF methodologies are easier to model and prepare, and require fewer assumptions from clients to develop;
  2. When acting as an opposing expert, and the other expert has used a CE/CCF methodology, it is often preferred by counsel to apply a similar methodology in order to provide an “apples to apples” comparison, even though the applicability of said methodology is questionable;
  3. Many clients do not have projections or visibility on the future performance of their companies;
  4. The CE/CCF methodologies often rely on averages or weighted averages of actual historical earnings or cash flow (often with normalization adjustments made), and therefore is easier to discuss with clients than trying to get clients to forecast the future; and
  5. The CE/CCF methodologies rely on historical performance to determine future results, and as a result, historical evidence of performance is much stronger to defend in court than forward-looking assumptions.

The Market Approach methodologies relies on market multiples to value a private company. These methodologies are often used when a private company is at an early stage and not generating positive earnings or cash flow (or cannot foresee when positive earnings/cash flow will be achieved). However, we have also encountered these methodologies used for more established, cash flow generating businesses, given its ease of use and some industry practitioners preferring these methods.

Similarly to the CE/CCF methodologies described above, valuations under the Market Approach apply a “snapshot” on current value (e.g., multiple on last twelve months revenue or EBITDA), rather than a forward-looking perspective on earnings or cash flow. In addition, public company multiples can fluctuate due to factors unrelated to the subject company, and M&A multiples represent market negotiated pricing that may or may not have similar characteristics to the subject company being valued.

Which Approach is Better for Preparing More Accurate and Reliable Valuations?

Although our preference is to use the DCF for most valuation situations, we do acknowledge that the other approaches have merit in specific situations:

  1. Where the market and/or investors are relying heavily on other valuation approaches (e.g., market approach), this should be used to determine notional valuations to ensure compatibility with investor expectations;
  2. Where a company is at its infancy with no realistic or credible view of when it will generate earnings or cash flow; and
  3. Where the company does not generate any commercial goodwill and is likely valued best using an asset approach.

In most other situations, we believe that the DCF provides more reliable and accurate business valuations in a notional context as it aligns best with what investors and finance professionals have adopted in Canada and around the globe. However, you should discuss the pros and cons of these valuation methodologies with your business valuator to better understand the rationale for its use.

Adam C. Nihmey, CFA, CBV
Managing Director, Valuation & Litigation Support
613-236-9191 x283
anihmey@w-group.com

Ottawa: 613.236.9191  |  Toronto: 647.288.9200

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