The seminal work on discounted cash flow valuation methodologies arguably is Tom Copeland’s Valuation.   For anyone who wishes to understand how many private equity firms think about financial models and define free cash flow, this is the place to start.

While DCF methodologies are a critically important tool in the determination of value for any business, I’ve been puzzled recently about the way in which smart investors deal with a few of the assumptions that underlie the analysis:

  • Product and business lifecycles have shortened.  DCF models depend on predictability of cash flows out many years.  This calls into question the ability to make accurate predictions of business fundamentals out more than a year or two.  I was startled to hear a few months ago that the iPod was launched around a decade ago (and the iPhone half as recent).  Creative destruction is more active than ever.
  • Macroeconomic volatility compounds the issue by introducing large externalities – i.e., a breakup of the euro zone – that can have an indeterminate impact on forward cash flows.  My good friend, Jim Surowiecki, wrote a book called The Wisdom of Crowds that provides very good examples of how decision making by smaller groups (i.e., politicians) is subject to wider dispersion than those by very large groups (i.e., the invisible hand).   We’re seeing the same thing with Europe and the US fiscal cliff, where it becomes difficult to quantify the downside when we can’t be sure that the key players will reach an economically rational equilibrium.
  • DCFs are highly sensitive to estimates of weighted average cost of capital.  It is clear that there are massive distortions in global interest rates, and equity market premia have effectively been negative for some time.  Consequently, this must have a real effect on the ability to accurately estimate a given company’s WACC.  Given that cash flows implicitly extend for decades, minute changes in the WACC will have a profound impact on present value.

Take the simple example of a firm with $100 of free cash flow that’s growing 5% per annum and we decide that a reasonable weighted average cost of capital is 10% today.  Calculated as a growing perpetuity, the firm should be worth $2,000 today.  However, 70% of the net present value is due to cash flows in years 11 through infinity.

What DCFs don’t incorporate are valuable options embedded in a business.    This was the case with cable companies, where they were erroneously priced as growing perpetuities in the 1990s (even though they needed to continually reinvest in their businesses, and hence free cash flow was depressed).  However, the value of “owning the biggest pipe” into the house was soon appreciated and understood by the market.

When we speak to managers, we prefer professionals who are always willing to question the assumptions underlying the analysis and maintain a healthy skepticism about the results on any single methodology.

Any insights from investors in the investment business – private equity, hedge funds, etc. – on how best to address these limitations would be more than welcome.

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