Michael Mauboussin on Common Errors in DCF Models
March 16, 2006
Discounted cash flow analysis is the most accurate and flexible method for valuing projects, divisions, and companies. Any analysis, however, is only as accurate as the forecasts it relies on. Errors in estimating the key ingredients of corporate value . . . can lead to mistakes in valuation.
Tim Koller, Marc Goedhart, and David Wessels
Valuation: Measuring and Managing the Value of Companies
A Return to First Principles
Say you had to come up with a fair offer to buy your local dry cleaner and the seller limited the extent of your financial information to the answers to five questions. Which questions would you ask?
Chances are you wouldn’t ask how the quarter is progressing or about last year’s earnings, but you would focus on the prospects for cash coming in versus cash going out over time.
Sole proprietors understand intimately that the value of their business hinges on the cash flow the business generates. No distributable cash, no value. Cash puts food on the table and pays the mortgage; earnings do not.
Equity investors are business buyers. While most shareholders own only a small fraction of a company, they are owners nonetheless. The source of shareholder value, and value changes, is no different than the sole proprietor’s: it’s all about the cash.
Most investors don’t think this way. In part, this is because market exchanges readily allow investors to trade cash today for claims on future cash flows, and vice versa, encouraging them to forget they are evaluating, buying, and selling businesses. Yet investors, as opposed to speculators, should never lose sight of their objective: buying a stream of cash flows for less than what it is worth.
Given that cash inflows and outflows are the lifeblood of corporate value, you might expect investors to be intent on measuring and valuing cash flows. Indeed, valuation in the bond and commercial real estate markets is all about cash. In practice, however, very few equity investors dwell on cash. Proxies for value, like earnings and multiples, dominate Wall Street valuation work.
Because markets are mostly efficient, investors can get away with using value proxies without awareness of what the proxies actually represent. The result is complacency and a false sense of understanding. As a consequence most investors don’t do fundamental valuation work; when they do, they often do the work incorrectly.
First principles tell us the right way to value a business is to estimate the present value of the future cash flows. While most Wall Street professionals learned about discounted cash flow (DCF) models in school, in practice the models they build and rely on are deeply flawed. Not surprisingly, the confidence level in these DCF models is very low. This faint confidence is not an indictment of analytical approach but rather of analytical methods. DCF models should be economically sound and transparent. Economically sound means the company’s return and growth patterns are consistent with the company’s positioning and the ample empirical record supporting reversion to the mean. Transparent means you understand the economic implications of the method and assumptions you choose. Most DCF models fail to meet the standards of economic soundness and transparency.
Here’s our list of the most frequent errors we see in DCF models. We recommend you check your models, or the models you see, versus this list. If one or more of the errors appear, the model will do little to inform your business judgment.
1. Forecast horizon that is too short. One of the most common criticisms of DCF models is that any forecast beyond a couple of years is suspect. Investors, therefore, are alleged to be better off using more certain, near-term earnings forecasts.