In: Finance
“Any single erroneous assumption can result in a negative effect where positive results were expected”.
Discuss what is meant by this statement using clear and vivid examples of estimate and assumptions in a DCF model. Use real life examples to support your analysis.
Discounted cash flow analysis is method of analyzing the present value of company or investment or cash flow by adjusting future cash flows to the time value of money where this analysis assesses the present fair value of assets or projects/company by taking into effect many factors like inflation, risk and cost of capital and analyze the company’s performance in future.
DCF analysis seeks to establish, through projections of a company's future earnings, the company's real current value. DCF theory holds that the value of all cash flow-generating assets-from fixed-income bonds to stocks to an entire company-is the present value of the expected cash flow stream given some appropriate discount rate. Basically, DCF is a calculation of a company's current and future available cash, designated as free cash flow, determined as operating profit, depreciation and amortization, minus capital and operational expenses and taxes. These year-by-year projected amounts are then discounted using the company's weighted average cost of capital to finally obtain a current value estimate of the company's future growth.
DCF Formula:
DCF= CF1/(1+r)1 + CF2/(1+r)2 + CFn/(1+r)n
CF = the cash flow for the given year. CF1 is for year one, CF2 is for year two, CFn is for additional years
r = the discount rate
Example of Discounted Cash Flow (DCF)
When a company looks to analyze whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital (WACC) as the discount rate when evaluating the DCF. The WACC incorporates the average rate of return that shareholders in the firm are expecting for the given year.
You are looking to invest in a project and your company's WACC is 5%, so you will use 5% as your discount rate. The initial investment is $11 million and the project will last for five years, with the following estimated cash flows per year:
Year | Cash Flow |
1 | $1 Million |
2 | $1 Million |
3 | $4 Million |
4 | $4 Million |
5 | $6 Million |
Therefore, the discounted cash flows for the project are:
Year | Cash Flow | Discounted Cash Flow | |
1 | $1 Million | $952,380 | |
2 | $1 Million |
|
|
3 | $4 Million | $3,455,425 | |
4 | $4 Million | $3,290,826 | |
5 | $6 Million | $4,701,089 |
If we sum up all of the discounted cash flows, we get a value of $13,306,749. Subtracting the initial investment of $11 million, we get a net present value (NPV) of $2,306,749. Because this is a positive number, the cost of the investment today is worth it as the project will generate positive discounted cash flows above the initial cost. If the project had cost $14 million, the NPV would have been -$693,251, indicating that the cost of the investment would not be worth it.
Here are the biggest problems of DCF:
1. Operating Cash Flow Projections
The first and most important factor in calculating the DCF value of a stock is estimating the series of operating cash flow projections. There are a number of inherent problems with earnings and cash flow forecasting that can generate problems with DCF analysis. The most prevalent is that the uncertainty with cash flow projection increases for each year in the forecast—and DCF models often use five or even 10 years' worth of estimates. The outer years of the model can be total shots in the dark. Analysts may have a good idea of what operating cash flow will be for the current year and the following year, but beyond that, the ability to project earnings and cash flow diminishes rapidly. To make matters worse, cash flow projections in any given year will most likely be based largely on results for the preceding years. Small, erroneous assumptions in the first couple years of a model can amplify variances in operating cash flow projections in the later years of the model.
2. Capital Expenditure Projections
Free cash flow projection involves projecting capital expenditures for each model year. Again, the degree of uncertainty increases with each additional year in the model. Capital expenditures can be largely discretionary; in a down year, a company's management may rein in capital-expenditure plans (the inverse may also be true). Capital expenditure assumptions are, therefore, usually quite risky. While there are a number of techniques to calculate capital expenditures, such as using fixed asset turnover ratios or even a percentage of revenues method, small changes in model assumptions can widely affect the result of the DCF calculation.
3. Discount Rate and Growth Rate
Perhaps the most contentious assumptions in a DCF model are the discount rate and growth rate assumptions. There are many ways to approach the discount rate in an equity DCF model. Analysts might use the Markowitzian R = Rf + β(Rm - Rf) or maybe the weighted average cost of capital of the firm as the discount rate in the DCF model. Both approaches are quite theoretical and may not work well in real-world investing applications. Other investors may choose to use an arbitrary standard hurdle rate to evaluate all equity investments. In this way, all investments are evaluated against each other on the same footing. When choosing a method to estimate the discount rate, there are typically no surefire (or easy) answers. Perhaps the biggest problem with growth rate assumptions is when they are used as a perpetual growth rate assumption. Assuming that anything will hold in perpetuity is highly theoretical. Many analysts contend that all going concern companies mature in such a way that their sustainable growth rates will gravitate toward the long-term rate of economic growth in the long run. It is therefore common to see a long-term growth rate assumption of around 4%, based on the long-term track record of economic growth in the United States. In addition, a company's growth rate will change, sometimes dramatically, from year to year or even decade to decade. Seldom does a growth rate gravitate to a mature company growth rate and then sit there forever.
Hence, any minor change in any of the above mentioned areas or anywhere else will lead to negative effects where positive effects were required.