Transcript In Defense of the DCF Methodology

DISCLAIMER
All rights reserved. No part of this work covered by the copyrights herein may be reproduced or copied in any form or by
any means—graphically, electronically, or mechanically, including photocopying, audio/video recording, or information
storage and retrieval of any kind—without the express written permission of the CTI, NACVA ,and the presenter.
The information contained in this presentation is only intended for general purposes.
It is designed to provide authoritative and accurate information about the subject covered. It is sold with the understanding
that the copyright holder is not engaged in rendering legal, accounting, or other professional service or advice. If legal or
other expert advice is required, the services of an appropriate professional person should be sought.
The material may not be applicable or suitable for the reader’s specific needs or circumstances. Readers/viewers may not
use this information as a substitute for consultation with qualified professionals in the subject matter presented here.
Although information contained in this publication has been carefully compiled from sources believed to be reliable, the
accuracy of the information is not guaranteed. It is neither intended nor should it be construed as either legal, accounting,
and/or tax advice, nor as an opinion provided by the Consultants’ Training Institute (CTI), National Association of Certified
Valuators and Analysts (NACVA), the Institute of Business Appraisers (IBA), the presenter, or the presenter’s firm.
The authors specifically disclaim any personal liability, loss, or risk incurred as a consequence of the use, either directly or
indirectly, of any information or advice given in these materials. The instructor’s opinion may not reflect those of the CTI,
NACVA, its policies, other instructors, or materials.
Each occurrence and the facts of each occurrence are different. Changes in facts and/or policy terms may result in
conclusions different than those stated herein. It is not intended to reflect the opinions or positions of the authors and
instructors in relation to any specific case, but rather to be illustrative for educational purposes. The user is cautioned that
this course is not all inclusive.
© 2013—1997 NACVA • 5217 South State Street, Suite 400 • Salt Lake City, UT, 84107—ALL RIGHTS RESERVED.
The Consultants' Training Institute (CTI) is registered with the National Association of State Boards of Accountancy (NASBA) as a sponsor of continuing professional education on the
National Registry of CPE Sponsors. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit. Complaints regarding registered sponsors may
be submitted through its web site: learningmarket.org.
2
The Presentation will include periodic online Polling
Questions/Codes to assess continuous participation and to
determine the program’s effectiveness.
You MUST respond to all polling questions (live) or keep
track of all polling codes (recorded) in order to receive CPE
credit.
If you view the webinar with a Smartphone or Tablet you will
NOT be able to answer polling questions that are required
for obtaining CPE credit.
If you are viewing this presentation as a recorded webinar it
will not qualify for NASBA QAS CPE credit. You can
however, obtain CPE credit per the instructions included
with your recorded webinar purchase.
© 2013 National Association of Certified Valuators and Analysts
3
In Defense of the DCF
Methodology
NACVA Webinar – Wed. Oct. 23, 2013
Presented by:
Richard R. Conn CMA, MBA, CPA, ABV, ERP
In Defense of DCF
PREAMBLE:
“Imagine a hypothetical company that had a provision in
its corporate charter prohibiting the paying of dividends
now or ever. The corporation never borrows any money,
never pays out any money to shareholders in any form
whatsoever, and never sells any assets … what would the
stock be worth? The stock is worth absolutely nothing.
Such a company is a financial black hole. Money goes in,
but nothing valuable ever comes out. Because nobody
would ever get any return on this investment, the
investment has no value.” (Stephen A. Ross et al.,
Fundamentals of Corporate Finance)
Conn Valuation Services Ltd.
5
In Defense of DCF
PURPOSE OF PRESENTATION
• Are there THREE methods of business valuation?
• Our purpose will be to question the accepted
norm that Income, Market and Asset/Cost are all
distinct, stand-alone business valuation
methodologies.
• My hypothesis: EVERY business valuation
methodology is a derivative of Discounted Cash
Flow
Conn Valuation Services Ltd.
6
In Defense of DCF
INCOME METHODOLOGIES:
Distinction between DCF and Capitalized Earnings/Cash Flow
• A Perpetuity is simply a DCF where the constant numerator
reoccurs on to infinity:
CFannual/ Discount Rate = PV, e.g.: $10/10% = $100
Same as: [$10/(1+10%)^1 + $10/(1+10%)^2 … + $10/(1+10%)^∞] = $100
Better written as:
∞
[$10/(1+10%)^i]
=$100
𝑛=1
where i = year of cash flow
• Note that there is no difference between a ‘Capitalization Rate’ and
‘Discount Rate’ when explicit long-term growth rate in the
numerator is zero (i.e. Cash Flows are REAL)
Conn Valuation Services Ltd.
7
In Defense of DCF
Capitalization Earnings/CF (cont.)
• Arithmetic and geometric sequences can be
captured in a single formula
e.g. Gordon Growth Method (GGM): Present Value = CF1/(r – g)
Where Cash Flow (or Dividends) are expected to grow at the constant
and perpetual rate of “g” [\ CF1 = CF0 x (1 + g)] and “r” is the discount
rate
GGM e.g.: $10.50/(10% - 5%) = $210
∞
DCF METHOD:
[($10 x (1 + 5%)^i)/(1+10%)^i] = $210
𝑛=1
Conn Valuation Services Ltd.
8
In Defense of DCF
Capitalization Earnings/Cash Flow (cont.)
• Other Income Capitalization methods such as
the ‘Excess Earnings Method’ is simply the
aggregate value of two perpetuities combined
CONCLUSION: Income Capitalization
Approaches are simply the DCF method that
have been conveniently represented by one or
more perpetuity formulae.
Conn Valuation Services Ltd.
9
In Defense of DCF
MARKET APPROACH
• Comes in various guises, but distinguishing
factor is that the indicator of value originates
from an observable unbiased Market
• Examples are Direct Transaction*, Guideline
Company, Market Multiple (e.g. P/E, P/EBITDA,
D/E, Industry Growth), even CAPM etc.
• Greatest Advantage: Objective Unbiased
Evidence representing actual transactions**
Conn Valuation Services Ltd.
10
In Defense of DCF
MARKET APPROACH (cont.)
• Greatest Disadvantage: Determining that the
market-based evidence is sufficiently similar
to Target (and/or justifying appropriate
adjustments to accommodate the differences)
• All market evidence originates from Market
Prices
• BUT WHERE DO MARKET PRICES COME
FROM?
Conn Valuation Services Ltd.
11
In Defense of DCF
MARKET APPROACH (cont.)
• Greater Fool Method of pricing securities
• Or, like the Greater Fool, you may not personally know why
The Market has priced a given security at $X, but you are
willing to accept the prediction of ‘Experts’ on that security’s
future direction
• But this approach begs the question “How do EXPERTS form
their opinions as to whether a given security is fairly, under or
over-priced?”
• Analytically there can only be one answer: The DCF Method.
Conn Valuation Services Ltd.
12
In Defense of DCF
MARKET APPROACH (cont.)
• As the trading in any security becomes more robust, more
expert attention is focused upon its price movements in order
to detect any potential for arbitrage (brief price deviations
away from FMV where a ‘riskless’ profit can be made). As a
result, Market Prices become self-correcting.
• But these experts really only have the DCF Method in their
financial tool bag with which to form an opinion of FMV.
• CONCLUSION: The MARKET APPROACH is that valuation
methodology where we rely upon the DCF Projections of
Others rather than conducting the DCF ourselves.
Conn Valuation Services Ltd.
13
In Defense of DCF
ASSET OR COST-BASED APPROACH:
• Which is it – Asset or Cost-Based?
• Asset-Based typically involve substituting B/S NBV values with
suitable MARKET values for that individual asset
• Cost-Based Appraisals originate from reconstruction or
replacement type quotes for unique assets
– e.g. A fixed-price, turn-key quote a general contractor might give to
rebuild the productive capacity of a given factory. To the quote
recipient, the single price is the COST of replacing the factory.
However, the only manner in which the contractor can logically arrive
at this conclusion is to create a detailed DCF including an array of all
possible risk contingencies.
Conn Valuation Services Ltd.
14
In Defense of DCF
ASSET OR COST-BASED APPROACH (cont.)
• INTELLECTUAL PROPERTY: It is difficult to conceive that IP
could ever truly be valued via a Cost-Based Approach …
typically these arguments transform into a comparable
Market-Based methodology (e.g. comparable royalty rates) or
an Income-Based DCF.
• Business Advantage – Preferred Location: Imagine getting
two cost-based quotes to build exactly the SAME consumer
retail structure (e.g. a gas station), one on a busy city
intersection and the other in a sleepy little hamlet, miles from
the nearest interstate. Would the cost estimate capture the
intrinsic value of the preferred location?
Conn Valuation Services Ltd.
15
In Defense of DCF
ASSET OR COST-BASED APPROACH (cont.)
CONCLUSIONS: An Asset-Based Approach really means the
accounting values of the Assets and Liabilities are being
individually replaced with Market-Based values (i.e. DCF’s
completed by other Market participants). Cost-Based values are
based upon the DCF’s that suppliers use to generate pricing
quotes.
Invariably most intangible assets are quantified either via a
Market-Based or DCF-Based approach. The more unique the
intangible asset is, the more likely that only a DCF model will be
suitable to quantify the value.
Conn Valuation Services Ltd.
16
In Defense of DCF
SUMMARY: Capitalized Earnings, Market-Approach
or Asset/Cost-Based Approach all ultimately reliant
upon the DCF. This is so because the very
motivation behind acquiring any business is to
generate future income. The value of the business
is directly related to how much future income is
expected and how much risk will be incurred.
However, this is not true of personal property for
consumption.
Conn Valuation Services Ltd.
17
In Defense of DCF
CAPITALIZED EARNINGS = DCF captured in one
formula
MARKET APPROACH = We are relying upon the
DCF’s other market participants have completed
ASSET OR COST APPROACH = Incorporate
Market Values or DCF’s completed by others
Conn Valuation Services Ltd.
18
In Defense of DCF
THANK YOU!
Richard Conn
www.connvaluation.com
[email protected]
Conn Valuation Services Ltd.
19