Valuation is an exciting area and at the heart of it lies the often derided discounted cash flow (DCF) method of valuing businesses. Many people make only half-hearted attempts at a DCF valuation but do it anyway because:
- it sounds “cool” to do it;
- it gives the illusion of precision; and
- it can be used as a tool to intimidate an uninformed audience.
A DCF does not automatically equate to a good valuation, with the old saying, “garbage in garbage out” fitting aptly to a DCF. DCF is only a tool and just like a knife it can be disastrous in the wrong hands. Used the right way though, it can be an excellent tool in investment decision making.
We often hear the complaint that it is rather easy to change the value of a firm in a DCF by simply tinkering with the assumptions. Yes, it is true, but at the same time it is also perfectly alright for that to happen. After all, your view of a business can be very different from ours and that is what gets reflected in the assumptions we use when valuing a business.
There are, however, certain fundamentals on which one cannot and should not argue. There are many errors that we see people commit in a DCF but, there is one particular mistake that makes our stomach churn. In this article we are going to discuss what this mistake is, its implications in valuation and why we get so worked up about it.
The mistake: Applying the terminal growth directly to the free cash flow at the end of the high growth period
This may seem like a small thing to fret over, but its implications can be massive. Let’s see how. We’ll take a hypothetical example comparing two scenarios:
- one where the terminal growth rate is applied to revenues and we work down towards the free cash flow from there; and
- the other where it is applied directly to the free cash flow at the end of the high growth period.
The two valuations along with the assumptions used are depicted below:
As you can see, we get vastly different results in the two situations. Let’s explore why this is so. The answer lies in the interplay between growth, reinvestment and returns on capital. Technically, growth in earnings come from two sources:
- Returns on the earnings that are reinvested back into the business; and
- Growth from efficiency, i.e. achieving better returns on existing assets.
Thus, growth can be depicted by the following equation:
Growth = Return on Capital * Reinvestment Rate + Efficiency Growth
Efficiency growth can come from improving cost structures, charging higher prices for the same level of volumes, etc. However, efficiency growth cannot last forever and hence it is reasonable to assume that it collapses to zero once the firm enters stable growth.
It means that growth in the stable phase comes only from the first half of the equation, i.e. reinvestment of earnings and the returns earned on those earnings. Thus, in the stable phase:
Growth = Return on Capital * Reinvestment Rate
This becomes a simple algebra problem in that if we can reasonably estimate two of the above three inputs, we can figure out the third.
- Growth in perpetuity: When we value companies on a going concern basis, we assume that the firm will run into perpetuity. That is a sweeping assumption and thus, it is better to restrict the growth rate to the risk free rate of the economy (more on this some other time).
- Return on capital: As companies mature, they are likely to attract competition, eroding their once high returns in the process. Thus, unless one has some special insight into a company, it is reasonable to assume that the return on capital will trend toward the cost of capital as companies approach stable growth.
In the above example, we have assumed the perpetual growth rate to be 6% and set the return on capital equal to the cost of capital at 10%. Based on these assumptions, the required reinvestment comes out to be 60% (6% / 10%). This means that a company which had to reinvest only 30% of its income every year to produce 12% growth for the initial 5-year period, now has to reinvest double that amount to produce a growth of 6% in perpetuity.
If, however, we apply the terminal growth to the free cash flow at the end of the high growth period, we implicitly assume that the company will continue to reinvest at the rate at which it was reinvesting in the high growth period, i.e. 30% in our scenario. Plugging these numbers into the equation, our growth rate should be:
Growth = 10% * 30% = 3%
This means that if the efficiency growth were zero, our perpetual growth rate should be 3%. Instead, we are assuming the company to grow in perpetuity at 6%.
It follows then that, the remaining 3% of the growth comes from efficiency and by applying the growth directly to the free cash flows, we have implicitly assumed this efficiency to go on in perpetuity. This is an unsustainable assumption and completely blows the DCF out of control. What’s more, this seemingly innocuous mistake overvalue’s the company by almost 57%!
Will this mistake always overvalue companies?
Not necessarily. It will result in an undervaluation in a situation where the company has to reinvest less in the stable period as compared to the high growth phase. If the reinvestment rate does not change from the high growth period to the stable growth, it will have no effect on value.
Some of the hardest mistakes to correct are those which slip under the radar and go unnoticed. Coupled with the magnitude of the errors that it can lead to, this in our view ranks amongst the top faux pas that one can commit while doing a DCF valuation.