Solvency Analysis A Primer on Applying Discounted Cash Flow
DCF models are commonly cited in valuation literature. They are viewed as relevant and appropriate in many valuation settings. However, it is important to assess the applicability of the technique in each valuation situation. In particular, the valuator should consider both the quality and quantity of information available before applying a particular technique. To apply the DCF technique, one must estimate future cash flows through a projection period of a specific number of years, then determine a terminal value and, finally, calculate an appropriate discount rate and apply it to both the cash flows and terminal value. In using such a model, it is important to have sufficient knowledge of the enterprise to determine appropriate cash flows.
The basic building block of a DCF model is the forecast of revenues. The DCF technique is relevant only if the revenue projections are reasonable. Otherwise, the approach provides a façade of accuracy that is not warranted.
In our practice, we have witnessed numerous applications of the DCF in solvency analyses. Many are applied appropriately; yet sometimes, one runs into situations where you have "garbage in, garbage out." If one does not have a detailed understanding of the business, the risk of error grows. A difficulty associated with a discounted cash-flow model is that the model requires a projection of multi-year sales forecasts with resulting cash-flow estimates.
Projecting Cash Flows
First, to estimate sales forecasts over the projection horizon is, in some cases, a daunting task. While it is often doable, it requires a reasonable justification for the specific sales levels assumed. Moreover, it requires an understanding of both the firm and the industry, such that sales can be appropriately transformed to cash-flow figures. Although it is often difficult to analyze mature industries and determine the relevant projections, it is much harder to make projections of firm cash flows in nascent industries, new enterprises or high-risk ventures. While it is possible to use a DCF in these situations, it requires significant analysis—beginning with the company's anticipated sales. Furthermore, the relationship between sales, profits and cash flows may be a complex one. The firm and/or industry may be rapidly evolving with new entrants, changing distribution methods, economies or diseconomies of scale, evolving production technologies, cannibalization of locations (retail) or others. Moreover, the valuation must assess not only cash flows from operations but also capital expenditures—namely, investing cash flows. One of the guideposts to assessing the viability of projections is a comparison to historical results. In mature industries, historicals are particularly useful. Yet, even in these industries, care must be taken into account for changes or modifications in the firm's business plan. However, the reasonableness of a business plan should be assessed. In recently created industries or firms with limited history, that history is still very useful. Both an analysis of the firm's historical sales and profitability (or losses) resulting from those sales is relevant, even when only a short history exists. Is the profit model of the firm viable? Can it generate sustainable and growing sales and cash flows? What assumptions are necessary to make the business viable? While it is usually risky (and difficult to support) for the valuator of a company with historical losses to project a successful, growing business starting immediately following a transaction and continuing for years into the future, it may be appropriate; yet it requires significant analysis and understanding of the issues driving sales, profits and cash flows. Situations with a short negative operating history must be considered carefully, particularly those with hockey stick projections, where falling or negative historical earnings and operating cash flows are immediately followed by positive and steadily growing future operating cash flows. Such a hockey stick, while possible, must be justified through analysis of the marketplace and the cost/revenue relationships anticipated. Furthermore, it is important to consider the relationship between investment cash flows and operating cash flows. The valuator must ask whether the firm is likely to be able to raise the funds necessary for its projected investment in plant, equipment, stores or warehouses if operating cash flows do not materialize. Without both satisfactory historical results and promising operating cash flows, it is often hard to raise investment capital. For companies requiring sizeable capital infusions, historical results may play an even more significant role.
Projecting a Terminal Value
A discounted cash flow model is predicated on cash flows predicted through a certain projection horizon of several years, with a terminal value then applied. While the projection horizon may be longer or shorter than four or five years, a longer horizon may well affect the potential reliability of the forecasts. This is particularly true if a firm is entering a new business area or if the firm is engaging in a high-risk venture. For example, it becomes extremely difficult to have a detailed extended projection for an Internet company, a high-technology firm or any firm with significant uncertainty about the future cash flows. To turn these projections into something more than speculation requires significant in-depth analysis of sales, competitors, profit generation capability, etc. Even with such analysis, it may not be possible to project the future cash flows with a degree of reliability sufficient to provide useful information.
It is also important to recognize that if a long-term forecast is used, the nature of the cash flow must reflect the type of company being considered. A growth company, for example, must have sufficient increasing investment outlays for a long enough time period to maintain its status as a growth company. A slowdown in investment may well lead to a slowdown in the generation of increasing operating cash flows, thus transforming the company "prematurely" into a mature company. For example, Starbucks, more than 10 years after its IPO, is increasing its investment outlays each year. The competitive environment, including the amount projected to be spent by competitors on capital expenditures, also plays a major role in assessing the projected capital expenditure of the subject company.
The firm's terminal value must also be projected. There are several approaches typically used for calculating a terminal value—a perpetuity of the firm's projected cash flows and a multiple approach of EBIT, EBITDA or other factors. The downside of the first is that an estimate of growth in cash flows must be developed. Such an estimate follows from an estimate of nominal sales growth into the future. It is typically reflective of a mature firm growing at or near the growth rate of the economy. The multiple approach relies on comparable mature firms in the industry. A downside of this second approach is that it is often conjectural to employ today's multiple approach (e.g., enterprise value to EBITDA) to determine the terminal value. In addition, EBITDA does not incorporate the firm's investment cash flows. Since investment cash flows are not included in EBITDA, they would not then be incorporated into the terminal value. A further consideration is whether the firm will remain viable to reach the terminal value. Based on information made available at the time of the projection, one must ascertain whether the firm will ever reach the period in which the terminal value is applied. Whether it is unlikely that the firm will be able to raise the necessary funds, or whether industry structure issues raise significant doubts about the firm's ability to compete or other reasons, one must assess the likelihood of reaching a zero terminal value. With some high-risk entities, it is likely that a firm will never reach steady state.
Incorporating a Discount Rate
The final component of the DCF analysis is the discount rate. Generally, the discount rate reflects the weighted average of the firm's cost of debt and equity. This discount rate is used to discount a firm's debt-free cash flows. These reflect the firm's cash flow from operations less its investing cash flows. Generally, the greater the risk of realizing the firm's projected cash flows, the greater the discount rate. The effect of increasing the discount rate is to reduce the present value of the firm's cash flows. The valuator must be careful to use the appropriate discount rate. A discount rate too low generally reflects an unwarranted bias toward solvency, while a discount rate too high may inappropriately show a firm to be insolvent. Determining a discount rate often involves the use of the Capital Asset Pricing Model or some alternative methodology to obtain the required return to the firm's equity-holders. Should the firm be private or not have a long enough track record as a public company, the valuator will likely use comparable companies to determine the cost of equity. When using such comparables, the valuator must be careful in selecting firms that truly are similar to the company being valued. Another approach to measuring the risk includes reducing expected cash flows over the horizon period and/or those cash flows contributing to the terminal value. A third approach is to consider a probability-weighted set of scenarios: High-probability scenarios will get more weight than those having a low probability, resulting in a probability-weighted cash-flow analysis. Care must be taken to appropriately consider and apply a discount rate or otherwise take into consideration risk.
Without properly applying a discounted cash-flow analysis, the valuator will generate a BEV not reflecting the value of the firm's assets. If this value is wrong, subtracting debt from the enterprise value will result in an incorrect measure of the firm's equity, and thus an incorrect conclusion regarding the firm's solvency.