Monday, September 5, 2011
Is DCF Becoming DOA?
One of the key financial tools available to strategic planning is Discounted Cash Flow (DCF). It is one of the accepted standards for evaluating a business. The basic idea is to take future cash flow expectations for the business and discount them back to today’s value based upon an assumed cost of capital. There are slight variations in how the cash flow is defined (such as the difference between accounting cash flow and the cash flow definition of EVA [Economic Value Added]), but the general principle is rather basic.
It is such an accepted tool in strategy that if you look at the requirements listed when a company is hiring a strategist, expertise in DCF is often demanded. After all, how can one evaluate alternatives if one has no way to put a value on them? And DCF is the standard accepted way to compute those values. Right?
Well, lately I have found that the DCF methodology is becoming less dependable as a valuation tool. In an increasing number of cases, it appears to me that standard DCF calculations are becoming less reliable—perhaps even deceptive—such that they may lead to the wrong conclusions.
In the rest of this blog, I will explain why I feel this way.
THE ASSUMPTIONS BEHIND DCF
For DCF to be a reliable way to evaluate businesses, one has to accept certain assumptions. The three most important are
1) Future cash flows are the primary determinant of business value.
2) Cost of Capital is relatively easy to determine.
3) Cash Flows are relatively easy to determine.
If any of these assumptions are not true, than DCF becomes a less reliable tool. The greater the number of assumptions that are untrue, the less sense it makes to rely on DCF as the primary valuation technique. And in my opinion, all of these assumptions are currently under attack.
ARE CASH FLOWS STILL THE PRIMARY DETERMINANT OF VALUE?
Let’s look at the first assumption: Cash flows are the primary determinant of value. This assumption makes the most sense if you plan on holding a business for a long time and manage it for profits. Since, in this case, profits are the manner in which the return on investment is achieved, then linking value to the cash flow thrown off through operations makes sense.
But what if the primary form of return on investment comes from something else? It seems that to an increasing level, most of the value created in a business comes at the point when a business changes hands.
It reminds me of professional sports teams. People pay a large fortune to own one of these sports teams. Yet, on an annual cash flow basis, most of these sports teams lose money. Based on DCF, these sports teams destroy value. The analysis would say that you should not pay much of anything for a sports team and maybe you should even be paid by the current owners to take it over.
Yet people still pay a fortune for these teams. Why? Well, there are a number of reasons, but one of them is the fact that, over time, the resale value for these teams increases. If, after a few years, you want to re-sell the team, one usually can get back far more than what one originally paid for the team.
In this example, all the value comes from the point when the team changes ownership. None of it comes from annual cash flows. Therefore, DCF is not a very reliable to for determining the value of a sports team. At one time, sports teams were a bit of an anomaly in this regard. Now, this is becoming more of the norm in the business space. We talked about this in an earlier blog.
Just look at all the valuations being created for all the digital businesses in the social networking space. Each level of valuation seems based on what happens at the next shift in ownership. Angel investors and early round funds are looking at how the value may rise when late round funders jump in. Late round funders are looking at how the value may rise when the firm goes public. Early IPO investors are looking for that early bump in stock prices which soon follow an IPO. The original entrepreneurs are at looking at what they can make when they can cash out.
The same thing applies to the rise in the investment funds and activist investors. They seem focused almost exclusively on getting value from ownership churn. Sometimes, they take businesses private in order to take them public again soon after, hoping that this churn will put extra money in their pocket. Or they want to break up a company because they think the ownership change in a break-up unlocks the “true” value. Or they want to put a company up for sale because they think a new owner will value the business more than current owners.
In both the start-up and the active investor cases, there is little desire to own the business and actually get the return out of the annual cash flow. Instead, the desire is to get the money out of the next ownership shift. If that is the case, then the business is no longer run to optimize cash flow, but to optimize resale value.
It’s like all the people who were flipping houses during the housing boom. They didn’t buy the house to live in it. They bought it specifically to resell quickly at a profit. They would make investments in the house based on what would best increase resale potential rather than what would make the most sense if you planned on living there. We spoke of this in an earlier blog.
This same thing is happening more and more in the business world. Cash flow is not the prime source of value. Pleasing the customer seems to be less important than pleasing the next owner. If you listen to startup firms discuss their strategy, it often sounds like the only “customer” they care about is the one they hope will provide the next round of funding.
In at a lot of these “profits from churn” strategies, it often looks like the investors, their lawyers and the investment advisors may get rich, but the company’s ability to create long-term cash flow actually shrinks. Lots of costs related to creating future value are stripped out (like R&D and maintenance). Instead, money is put into superficial things which may dazzle the next owner, but don’t lead to a better business (sort of like “curb appeal” in selling houses has little to do with living in them).
Based on all of this, I think that cash flows are losing some of their linkage to how value is created
(and how businesses are run). This makes DCF a less effective tool.
IS THE COST OF CAPITAL EASY TO DETERMINE?
There is a simple formula in DCF to determine cost of capital. It looks at risk-free rates of return and adds a factor for industry/business/stock market risk. The risk free rates usually are based on government debt rates. However, since the great recession, it seems that governments are setting their debt rates at levels which have nothing to do with the “true” cost of debt for a business. There are other political and social factors at work. Sovereign debt in many parts of Europe is so messed up that it makes its usefulness as a tool in calculating DCF for businesses much more problematic. Even US Treasuries, which were supposed to be the perfect risk free measure, are complicated by the ratings reduction of US debt by S&P.
Japan has been distorting its debt situation for a long time. There is also little trust in how debt and equity work in China (and that’s where a lot of new business valuations are taking place). These policies distort how businesses invest, in ways that have nothing to do with cash flow prospects.
Between all the volatility and uncertainty in the debt and equity space, I think it is getting increasingly more difficult to determine what a true cost of debt and a true cost of equity should be. And with all the pre-planned churn for taking businesses in and out of equity, I’m not as certain as to how to even factor cost of equity and debt into the calculation.
I was thinking about this recently, while listening to some “business experts” on TV discussing some of the implications were of some of the wild valuations of deals recently taking place. Using the rules associated with DCF, the commentators did the math backwards and concluded that, based on the valuations, companies must have an irrational expectation for cost of capital. No, I think it meant that DCF no longer set the rules as much as in the past. The math didn’t apply.
ARE FUTURE CASH FLOWS RELATIVELY EASY TO DETERMINE?
With a lot of the new social businesses going public, like Groupon, Linked In, Facebook, etc., there are wild speculations about what the future may hold. Heck, some of the businesses being looked at have never made a profit, yet are being valued very highly. And for those making a profit, the valuations assume that profits will grow at astronomically high rates for a long time in order to justify the price. There is almost no scientific, rational way to “prove” the validity of these abnormal assumptions, where history seems to have no bearing on the future.
In times like these, people place their investment bets not based on DCF math, but on what they think mob psychology might lead to, even if they don’t think the mob is correct. Supply and demand math takes precedence over DCF math.
Although DCF calculations still have merit, recent circumstances are making DCF less reliable as the sole source for value calculation. One needs to also consider how other factors influence value, like frequent changes in ownership, laws of supply and demand, non-typical government stances on monetary policy, etc. Otherwise, one may miscalculate value and make poor strategic decisions. So, although it’s too soon to say that DCF is DOA (Dead on Arrival), I think one can say that the health of DCF is not as strong as it used to be.
We merely scratched the surface on this topic. For the sake of length, I cut the discussion short. If you would like to continue the discussion, feel free to leave a comment.