DCF Sense Checks
What are “DCF Sense Checks”?
DCF valuation relies on the valuer’s own cash flow forecasts, which are in turn dependent on many assumptions. This reliance on assumptions is both a strength and a weakness of this method; a strength because these assumptions require an analyst to think in detail about the company’s business drivers and future performance but a weakness because the final valuation is often highly sensitive to the assumptions. It is important to remember that the reliability of the DCF valuation is dependent on the quality of the assumptions. Aswath Damoradan (a well-known writer on valuation) calls DCFs that fall into the common pitfall of poor assumptions amusing names such as ‘dissonant’ ‘dreamstate’ or ‘robo’ DCFs. These show that although DCF is a powerful technique, it’s a recognised problem that they may fail due to poor inputs.
To avoid creating a bad DCF, analysts must undertake sense checks to test the assumptions used.
Key Learning Points
- DCF relies on the valuer’s inputs and assumptions. The reliability of the valuation is dependent on the quality of the assumptions.
- Small changes in the assumptions can producinge large value variations.
- The reliance on many assumptions in DCF analysis is both a strength and a weakness of this method
- DCF valuation is very dependent on key assumptions with even small changes producing large value variations
- Sense checks help in checking the reasonableness of these assumptions and the resulting output
The Need for DCF Sense Checks
A DCF analysis calculates the value of a business as the present value of its forecasted free cash flows. A strength of DCF analysis is the requirement to think about and forecast key business drivers. This leads to a fuller understanding of the business fundamentals. It also serves as an important counterpoint to market-based valuation techniques, which may sometimes be vulnerable to market distortions.
However, DCF valuation is very dependent on key assumptions with even small changes producing large value variations. Sense checks help in checking the reasonableness of these assumptions and the resulting output.
DCF Sense Checks Explained
To recap from our earlier blog on DCF analysis, here are the steps involved in undertaking a DCF analysis:
- Forecast free cash flows to steady state (normally 5 or 10 years)
- Calculate Weighted Average Cost of Capital (WACC)
- Calculate terminal value
- Discount cash flows to the investment date
- Calculate implied share price from enterprise value using the bridge
We look at the sense checks undertaken at the various stages of DCF valuation.
Sense Checks on Key Ratios after Calculating FCF
Sense checks can be done by:
- Trend analysis over time: Are the values within the expected range?
- Peer comparison: Are the results consistent with peer company metrics?
- Analysis of interrelated metrics: Do related values move as expected relatively?
Some checks that can be performed after calculating free cash flows are summarised in the table below. If you’d like to see the checks in action you can find an annotated model and DCF in the download section which applies and comments on most of these checks for a DCF valuation.
|
Sense check |
Reason |
|
| Sales growth | Should match long term growth by the final year | If not there’s a mismatch between the growth (and reinvestment) in the final FCF, and the subsequent growth that’s predicted in the perpetuity. Understand terminal value complexities. |
| EBIT margin | Should be converging towards the margins of mature companies in the same industry | A company in steady state shouldn’t be earning very high profits compared to mature companies in the same industry. |
| Capex as a % of sales | Benchmark against comparable mature companies. This should be logical given sales growth rates | A bad set of capex assumptions relative to revenue growth could leave the company with ‘free’ return. Return they haven’t had to buy assets to create. The company will need to keep investing for growth |
| Operating Working Capital as a % of sales | Benchmark against comparable mature companies. This should be logical given sales growth rates | This shares the same logic as capex as a % of sales |
| Return on Invested Capital (NOPAT/(equity + net debt) ) | Should be stabilizing towards the WACC by the steady state
Care should be taken with this analysis of intangible-heavy companies |
Given the stabilizing margins and the continued need for investment (all explored above) the ROIC should also be stabilizing
Companies with a lot of assets not captured on their balance sheets, such as brand-heavy companies, may not have invested capital that reflects their real assets |
| Replenishment ratio (Capex/depreciation) | When in a steady state, should be just over 1 (assuming inflation). Check the ending PPE balance to see if it is moving in line with sales | Capex and depreciation need to make sense relative to each other. A mismatch can cause PPE to grow or shrink unrealistically. A poor set of assumptions may see PPE grow exponentially, or dwindle even in a forecast growth company |
| Cash conversion rate (FCF/NOPAT) | Should be increasing, then stabilizing towards a steady, high state | As the company matures it should be investing less to achieve more modest growth. This means more profits becoming cash flows, rather than going into e.g. capex |
Sense Checks on Terminal Value
Since the terminal value is normally a large proportion of the overall value, the reasonableness of the forecast must be sense checked. In addition to sense checking the ratios above in the steady state, the following calculations provide a sense check on the terminal value:
|
Sense check |
Reason |
|
| The implied multiple from the terminal value (see below for method) | Benchmarked with comparable multiples | Comparables are readily understood by investment bankers and other financial professionals. Experience with comparables will give a feel for what a realistic comparable is for the industry. This experience can be used to compare the terminal value calculated by growing perpetuity with the multiple it represents |
| Long term growth | Compared to the long-term nominal GDP growth rate | If the company outpaces the economy in perpetuity it will lead to unrealistic valuations |
| The PV of TV compared to the PV of the explicit forecast period | Your organisation or team may have guidance on what an acceptable proportion is. High growth industries may have a higher acceptable proportion in the terminal value | A PV of terminal value that dominates the valuation may be correct, as it represents a much longer time-period than the explicit growth period. However, a big mismatch can be indicative of poor assumptions |
Sense Checks on the WACC
| Capital structure (debt/equity) | Benchmark against mature companies in the same sector | The WACC should reflect the long term financial risk of the company |
| Unlevered beta | Benchmark against comparable mature companies in the industry | The WACC should reflect the long term business risk of the company |
Sense Checks on the Output
As part of DCF analysis, the following calculations should always be undertaken and benchmarked:
| Implied share price as a % of the traded share price | If dramatically different, then the assumptions made by the market are different to those used in the DCF | The possible reasons to explain why should be explored, as the user of the valuation will want to know why the conclusion is so different |
| EV / EBIT or EBITDA multiples implied by the DCF | Benchmark against comparable mature companies in the industry | This shares the same logic as checking the terminal value, except now you would be checking the entire enterprise value |
Conclusion
Building a model and creating a DCF on it should be seen as an iterative process. The output will be used to check the inputs. New iterations will mean new checks. This will reveal problems and enable the analyst to get a deeper understanding by checking ‘problem’ assumptions. This will all lead to a stronger valuation, and it is an important skill for anyone creating DCF valuations.