Question

With respect to the market multiple model, name and describe some of the advantages/disadvantages of both the Discounted Cash Flow (DCF) and the Residual Operating Income (ROPI) valuation models.

Answer 1

                                                              Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF) Valuation estimates the intrinsic value of an asset/business based upon its fundamentals.

Intrinsic Value of a business is the present value of the cash flows the company is expected to pay its shareholders. DCF Valuation is the basic foundation upon which all other valuation methodologies are built.

Advantages

DCF Valuation truly captures the underlying fundamental drivers of a business (cost of equity, weighted average cost of capital, growth rate, re-investment rate, etc.). Consequently, this comes closest to estimating intrinsic value of the asset/business.

Unlike other valuations, DCF relies on Free Cash Flows. To a larger extent, Free Cash Flows (FCF) are a reliable measure that eliminate the subjective accounting policies and window dressing involved in reported earnings. Irrespective of whether a cash outlay is categorized as an operating expense in P&L, or capitalized into an asset on balance sheet, FCF is a true measure of the money left over for investors.

Besides explicitly considering the business drivers involved, DCF allows investors to incorporate key changes in the business strategy in the valuation model, which otherwise will go unreflected in other valuation models (like relative, APV, etc.)

Disadvantages

DCF Valuation is extremely sensitive to assumptions related to perpetual growth rate and discount rate. Any minor tweaking here and there, and the DCF Valuation will fluctuate wildly and the fair value so generated won’t be accurate.

It works best only when there is a high degree of confidence about future cash flows. But if the company’s operations lack visibility, it becomes difficult to predict sales, operating expenses and capital investment with certainty. While forecasting cash flows for the next few years is difficult, pushing them out perpetually (mandatory for DCF Valuation) becomes almost impossible. As such, DCF method is susceptible to error if not properly accounted for these inputs.

One major criticism of DCF is that the terminal value comprises far too much of the total value (65-75%). Even a minor variation in the assumptions on terminal year can have a significant impact on the final valuation.

DCF Valuation is an ever-changing target that demands constant vigilance and modification. If any expectations about the company change, the fair value will change accordingly.

DCF Model is not suited for short-term investing. Instead, it focuses on long-term value creation.

                                                                                         ROPI

The residual operating income (ROPI) model focuses on net operating profit after tax (NOPAT) and net. operating assets (NOA). This means it uses key measures from both the income statement and balance. sheet in determining firm value.

Advantages of the RI Model

Because terminal value is not as significant in the RI model when compared to other models, there may be greater certainty in the valuation.

The model is driven by publicly available accounting data.

The model does not require a dividend payment.

The model is not impacted by near term negative or unpredictable cash flows.

The model captures economic profit.

Disadvantages of the RI Model

The model is vulnerable to accounting manipulation by company management.

The model requires that the analyst have sophisticated understanding of public financial reporting, as large adjustments to reported financials may be required.

Similar to the previous point, the model requires a clean surplus relationship.