A follow up to the “biggest mistake in a DCF”

In this post, we discuss the distinction between returns on legacy vs. new investments and how they may be useful in assessing the impact of disruption.

Last week, we wrote a post on what according to us is the biggest mistake that people commit while doing a DCF valuation. In that post, we took a hypothetical firm that earns 40% return on capital (RoC) over the high growth period (5 years) which declines to 10% during the stable growth phase.

The post has since led to some interesting discussion and questions.

One such question was whether it is reasonable to assume such a drastic fall in fortunes from the high growth phase to the stable phase? It’s a fair question as a fall from a 40% to a 10% RoC appears unrealistic on the face of it. But is it really so? Let us explore.

Legacy vs. new investments

DCF models are set up with an inherent assumption that the RoC in the stable phase applies only to new investments and that the old “legacy” investments continue to earn previous high returns. This can be understood better by keeping track of the invested capital each year:

We can see that during the high growth phase, the firm keeps earning 40% return on its overall invested capital as well as on new investments. When it reaches the stable growth period, however, the return on capital starts declining. The 10% return on capital in the stable phase has the effect of gradually reducing the overall return on capital of the firm but it still remains well above the 10% assumed in the terminal year. Thus, what appears drastic, is not actually so.

Implications in the real world and a case for assessing disruption

There are many real world examples where firms are unable to find attractive opportunities to invest their capital as they (or the industry to which they belong) transition from high growth to maturity. We have discussed an example of Infosys to elaborate on this point at the end of this post.

The more interesting analysis, however, is in assessing ‘what-if’ questions using a DCF framework. One such question that we have been trying to answer is what happens when a business gets disrupted? Can a DCF framework be used to guide us as to the potential value loss in such a scenario?

A disruption can play out in many ways – decline in sales (negative growth rates), declining operating margins, etc. It is also possible that when a business gets disrupted, it not only affects its ability to earn returns on new investments but, its legacy investments itself become threatened. A DCF framework allows us to tweak these assumptions to assess the possible impact of such a scenario. For instance, in our hypothetical example if the firm’s return on existing capital drops to 25% and 10% on its new investments, this is how its value will get eroded:

We are not suggesting that a DCF will tell you exactly how much of a business’ value will get eroded. That of course has  to be assessed on a case-by-case basis. However, what it allows us to do is test various scenarios to assess probable impact of disruption on a business’ value and estimate an appropriate margin of safety to guide our investing decisions.

We’ll again reiterate the real value of a DCF. It is not in getting precise numbers at the end of a valuation. It is in the insights that we can gain on the key variables affecting the value of a business which allows us to spend more of our time in assessing those variables.