Joao Mynarski, ASA

Principal, Mynarski International Valuation

Abstract: While discounted cash flow (DCF) analysis is a preferred approach to valuing companies, such analysis can be susceptible to value discrepancies arising from the key factors of financial projections, discount rate and projection period. This article highlights some important issues regarding those factors and discusses how they might be considered in an appraisal review.[JC1] 

Discounted Cash Flow Analysis

Due to its practicality, discounted cash flow (DCF) analysis is widely used in business valuation and has become the preferred theoretical approach among academics and the favored tool within the financial community for valuing companies.

This analytical model is based on the key factors of financial projections, discount rate and projection period. However, because DCF analysis is highly susceptible to value discrepancies arising from small variations to these factors, it seems appropriate look at its weaknesses with a view to ensure greater accuracy of business valuation reports.

This article will address the three factors of period, discount rate and financial projections, discussing some important issues and offering some points to consider when conducting business valuations or reviewing business valuation reports.

Period

The length of the period covered by financial projections must represent the useful life of the company or the estimated period that the company will maintain its operations.

How can we reasonably define this period?

Market research, based on official institutes, questionnaires and consultation, conducted among similar companies seems to be the best alternative to define the useful life of companies and thus determine the period of financial projections. A valuation that assumes a company will keep operating forever (in perpetuity), fails to consider the life cycle of companies, and such theoretical reasoning is not confirmed in practice. If the valuation does assume perpetuity, some points require particular attention:

• The company should not be a startup, as projections are uncertain during this phase in company’s life;

• The company must have a relatively good market share and generate sufficient cash to allow investments and overcome crises;

• The company must continuously invest in new technologies and innovations;

• The company must be constantly alert to new market opportunities;

• Any successor must maintain or expand on the above items;

• The company should not be subject to any great threat to its ability to do business.

These issues regarding financial projections need to be carefully analyzed to ensure business valuation reports are as accurate as possible.

Discount Rate

The discount rate is dependent on market fluctuations, but the market is made up of people susceptible to emotions (for example, enthusiasm, fear, and greed), which directly impacts stock pricing and interest rates and creates distortions.

When using data from the stock exchange to analyze companies, care needs to be taken to ensure the companies have the same scope, structure, and  market share and whether the stock exchange represents the market under study If there are differences, the analysis will not be truly representative.

Sometimes it is more precise to define the business risk through a detailed questionnaire and local research than to use indices that do not represent the analyzed company.

Financial Projections

The reliability of financial projections is extremely important in business valuations, and precision diminishes the longer the period the projection seeks to cover. So, in the short term a projection might be highly reliable, but as time goes on the projection is likely to be less precise.

This diminished reliability arises from the difficulty of estimating future market changes and financial flows. Moreover, simply applying constant projections over the long-term aggravates this situation. It is more appropriate, therefore, whenever possible, to use variable projections that take into account the company’s cycles and may even consider variations to income and expenditure during the projection period.

Analyses of the business plan, revenues, production capacities, market, technology, labor, risks, opportunities, and so on, make it possible to estimate the growth rate in the projections. Nonetheless, care must be taken during such analyses because each company is unique and, as such requires tailored treatment.

When preparing financial projections, we shouldn’t forget to analyze the following items:

• The probability of bankruptcy is rarely considered;
• Long-term projections must be conservative, as they are based on fragile assumptions, with little foundation. Nevertheless, according to Berkman, Bradbury and Ferguson, Copeland, Koller and Murrin and Buus the weight of the company’s terminal value can be considerable (over 50%), which constitutes a very high risk for investors;
• If there is perpetuity, the perpetuity growth rate cannot exceed the economy’s growth rate;
• Estimating the growth rate in the terminal period may be better accomplished using a detailed questionnaire than by macroeconomic or sectoral estimates;
• CAPEX should consider the remaining (productive) useful life of the assets and not the accounting depreciation rate;
• The feasibility of implementing the company’s strategic plan must be verified.

Conclusion

The practicality of using discounted cash flow (DCF) analysis in business valuation depends upon the reliability of the key factors involved: the financial projections, discount rate and projection period. This brief commentary on issues to consider when determining these factors can be useful in the preparation and review of business valuation reports, and may stimulate feedback from the academic and professional communities interested in business valuation.

About the Author

Joao Mynarski, ASA, FRICS, IVSC, is the principal of Mynarski International Valuation in Latin America. Joao earned a degree in civil engineering in 1983 from Pontificia Universidade Católica do Rio Grande do Sul. He went on to specialize in appraisal at UFRGS, Federal College of Economics; UCLA, Berkeley Extension; and IBEF, Institute of Finance Executives[JC1] . He started Mynarski International Valuation in 1991; the company offers a full range of appraisal and valuation services, asset management, business combination and software development in all business sectors for corporations, investors and funds. Email joaocarlos.mynarski@mynarski.com