“There are three obvious shortcomings of the DCF approach. One, it ignores key information — namely the value of the assets in the business. Two, it takes very good information which is the near term cash flow projections, and very uncertain information, the terminal value which is supposed to capture the value of cash flow beyond four years, and adds them together. Naturally, the bad information dominates the valuation. Three, it does not account explicitly for industry competition which is a critical — if not THE critical — factor, affecting valuation.”
Prof. Bruce Greenwald
New York, USA
Two months ago, we were commissioned to research two seemingly different cases.
The first was to investigate and conduct a valuation of a profitable company that our client wants to buy. The second was to find the value of another profitable company whose owner (our client) wants to sell. They both asked for a comprehensive and fully substantiated valuation that they could present to their counterparts.
The DCF Method
A look at 7 presentations of valuations conducted by banks or consulting companies, revealed that they were all very similar as to their methodology. They were based on a projection of the future five year performance of the companies involved. It was a prediction of both the annual cash flow the company will generate and a projection of the terminal value of the company at the end of the five years that the investor will own.
This is the most popular method used for the valuation of companies, at least in Greece. It is the DCF (Discounted Cash Flow) method. Most negotiations are based on this methodology.
There are quite a few problems with DCF as Prof. Bruce Greenwald commented above for this article, the most worrying of which is that it is based on future assumptions about the performance of a company. It makes five (if not more) year predictions on the company’s sales, gross margin, growth rates, operating profit margins, tax rates and its terminal value. As we all know, these are very hard to predict.
Can anyone predict with any degree of reliability the annual cash flows to the investor an investment in Apple would produce? Can anyone predict what the price of Apple will be five years hence? Or is DCF a method used for its seeming precision and ease of calculation?
The Value Investing Method
Another philosophy on Valuations is more comprehensive. It is based on Bruce Greenwald’s and Judd Kahn’s book1 and it is the methodology used by Value Investors, the best known of whom is Warren Buffett.
Greenwald’s and Kahn’s methodology, which we follow, takes a deep dive into the company’s last ten year performance. It examines both the Balance Sheets and Income Statements, adjusts them as appropriate and comes up with two valuations.
One is the Reproductions Cost of the company’s assets today (derived from the Balance Sheets), based on updated tangible and intangible assets like receivables, inventories, buildings, machinery, goodwill, etc. The other is the Earnings Power Value, which is based on the adjusted Income Statements of the last 10 years.
It then combines the two and arrives at some well substantiated conclusions about the realistic value of the company as well as the competitive environment in which it operates.
Finally, it looks carefully into the company’s current competition, its possible future competition (if we could imagine it) and considers the sustainability or not of any competitive advantage the company enjoys.
The Corporate Dilemma
We have long struggled with our personal dilemma of whether to follow what our competitors do (which might bring us more customers as it is better understood) or use a methodology in which we have more confidence. I trust we have resolved it even at a cost. We choose the hard and time-consuming methodology. We owe it to our customers who entrusted us whether they want to sell or buy.
We are open for any questions, comments, discussion if you so wish.
Company Valuations: Fast- Effective- Economical
1 Bruce C. Greenwald, Judd Kahn- Value Investing, Second Edition, WILEY 2021