Wednesday, 9 November 2016

Time to Trash Discounted Cash Flow as a Valuation Tool

I have never been a fan of company valuations based on DCF (Discounted Cash Flow) models. The uncertainty is too large, small changes in a few parameters will give wildly different valuations and the important parameters are never revealed (in other words, minority investors who disagree with the valuations can't fight them).

Not surprisingly, it is the "weapon of choice" for any financial engineer who is asked to come up with some crazy high valuation for instance for a Related Party Transaction (as unfortunately is too often the case in Malaysia). Just tinker a bit with the growth rate until the preferred value appears.

Arturo Cifuentes, Ph.D., an adjunct professor of business in the Finance & Economics Division of Columbia University, puts it more eloquent in this article, some snippets:

Joel Dean, an American economist who died in 1979 and made important contributions to corporate finance, introduced the Discounted Cash Flow (DCF) approach as a valuation tool in 1951.  The thought was that if the Net Present Value (NPV) of the cash flows of an asset or project, estimated with the DCF method, was positive, the investment was worth pursuing.  The idea was motivated by an analogy with bond valuation.  It had long been established that the price of a bond corresponds to its future cash flows, discounted with a rate determined by the market – a rate determined primarily by the credit risk associated with the issuer.

However, the analogy between bonds and project cash flows is not as clean as it seems.  In the case of a bond, the future cash flows are well-defined.  In essence –and this is critical – the uncertainty in the bond cash flows derives from the issuer’s potential inability to pay (credit risk). But there is no uncertainty as to the amount to be paid.  To put it differently, the bond has no upside.  Therefore, the probabilistic distribution of the cash flows is one-sided; it only includes downside scenarios.
In contrast, the uncertainty in a project comes from not knowing the cash flows rather than from the capacity of the project to pay them.  Moreover, even if we make an optimistic estimate of the cash flows, there is always the possibility to exceed that estimate.  That is, the cash flow distribution is two-sided: There is upside and downside potential.

These differences are further exacerbated because the life of a project is not as clearly defined as the time-to-maturity of a bond.  Project cash flows have notoriously uncertain lifespans.  Strangely, economics textbooks never address the shortcomings of the project-bond valuation analogy.

His conclusion:

Much of the problems affecting the DCF method come from the fact that it tries to capture with one factor – the discount rate – two completely different effects: the time value of money and the stochastic nature of the cash flows.  Not only that, it attempts to transform a problem which is probabilistic in nature (cash flows are uncertain) into a deterministic problem by appealing to the “right” discount rate.

Finance is undergoing a major review of its fundamentals as a result of the subprime mortgage crisis.  Markets are more complex, more psychologically driven, more interconnected, and more unstable than previously recognized.  The limitations of models based on questionable assumptions (normal distributions, stable volatilities, simplistic utility functions, efficiency of markets, rational decision makers, etc.) are being re-examined.  There is no reason to exclude the DCF from this exercise.

In light of these arguments, there is a strong case for refocusing research on valuation techniques.  We should abandon efforts aimed at determining the “correct” discount rates.  An honest assessment of these efforts inevitably leads to one conclusion: After years of investigating this topic, basic guidelines are as elusive as they were 50 years ago.  Instead, we should shift gears and focus on developing good tools aimed at characterizing cash flows probabilistically.  That is, at developing tools to estimate their means, standard deviations, and correlations.  Moreover, the merits of incorporating into the valuation calculation the benefits that a project could bring to the relevant stakeholders, as well as the risk tolerance of the potential investors, should be explored.

It is, in any event, unacceptable to argue that the complexity of cash flow valuation makes it an exception that can only be handled through amorphous concepts like discount factors and not with the normal rules of probability and statistics.

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