Discounted Cash Flow (DCF): Handle with Care

Valuators and damages experts commonly use the discounted cash flow (DCF) method to determine business value or calculate lost profits damages. The DCF method is a powerful tool, in part because it’s forward-looking. But because the method incorporates several assumptions based on subjective judgment, courts tend to scrutinize DCF calculations. Typically, courts demand that valuation experts explain these assumptions as well as demonstrate they are based on market-derived evidence and align with the facts of the case.

How DCF Works

In using the DCF method, a valuator measures value or lost profits based on a company’s expected future financial performance. Historical performance is relevant only to the extent that it provides insight into trends and future expectations.

At the same time, the valuator relies on several key assumptions, including cash flow projections, growth rates and discount rates. Each of these assumptions involves some element of subjective judgment, so each could be susceptible to manipulation in an effort to reach a desired result.

An appraiser begins by projecting future cash flows over a particular time horizon — usually five or 10 years. He or she then discounts those cash flows to present value. The discount rate, which reflects the time value of money as well as the level of risk associated with an investment in the business, is the rate of return that would be required by a hypothetical investor in the business.

The next step is to calculate a terminal, or residual, value — that is, the company’s estimated value at the end of the projection period. A valuator may use a few different approaches to determine the terminal value. One common approach is to assume that a company’s cash flow will continue to grow at a constant rate into perpetuity. The valuator then calculates the present value of those cash flows at the end of the projection period.

Another approach is to use an exit multiple model. A valuator employing this approach determines terminal value using a multiple — typically derived from transactions involving comparable companies — of some earnings or cash flow measure. After deriving the terminal value, the expert discounts it to present value and adds it to the net present value of projected cash flows to arrive at a value for the business.

Key Assumptions

It’s important to note that the accuracy of the DCF method is only as good as its underlying assumptions. These include:

Cash flow projections. Valuators examine several factors when projecting cash flows, including the past financial performance of the business or of similar businesses, prevailing economic and industry conditions, anticipated costs, working capital needs, and expected growth rate.

Often, experts rely on projections that management has prepared in the ordinary course of business. Indeed, many courts find management projections to be the most reliable predictors of future cash flows, given management’s intimate knowledge of the business, the industry and the market. But courts are suspicious of, and may reject, management projections prepared outside of the ordinary course of business, particularly if the likelihood of litigation creates an incentive to manipulate the results.

Discount rate. It’s customary for a valuator to determine the discount rate based on the company’s weighted average cost of capital (WACC). WACC incorporates the costs of both equity and debt to determine a discount rate that reflects the company’s overall capital structure. (See “What’s the cost of capital?”)

Given the level of subjective judgment involved in determining the discount rate, and the significant impact of even small variations, this is an area ripe for manipulation. Suppose, for example, that a business has projected cash flows of $10 million per year over the next 10 years. Using a 10% discount rate and assuming simple annual compounding, the present value of those cash flows is approximately $61.4 million. Reducing the discount rate to 8% increases the present value by $5.7 million, to $67.1 million.

Terminal value. Estimates of terminal value may vary substantially depending on which model experts choose and which inputs (for example, growth rate, multiple, discount rate) they select.

Explain, Explain, and Explain

Application of the DCF method involves a variety of assumptions and significant judgment. To pass muster with the courts, experts need to clearly explain the reasoning behind their assumptions and show how their analyses align with the facts and circumstances of the case.

Sidebar: What’s the Cost of Capital?

The weighted average cost of capital (WACC) is the combined cost of a company’s debt and equity capital. Typically, the debt component is based on the company’s actual borrowing costs (adjusted to reflect the tax benefits of interest deductions). To determine the cost of equity, a valuator usually uses approaches — such as the capital asset pricing model (CAPM) or the build-up method — that involve identifying a “risk-free” rate of return and adding market-based and company-specific risk premiums.

A key assumption in calculating WACC is the capital structure — the relative percentages of debt and equity that form the basis for weighting. When valuing a minority interest, experts usually use the subject company’s actual capital structure. But when valuing a controlling interest, experts often use the company’s optimal capital structure, under the theory that a controlling owner has the power to change it. To determine the optimal structure, experts may look to industry averages, capital structures of comparable companies or lenders’ debt-to-equity criteria.

 

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