There are many different ways to value a business, but one of the most common methods you are likely to come across is the discounted cash flow model. In a nutshell, this method estimates the intrinsic value of a company by looking at how much cash it is going to generate in the future, and calculating the "present value" (what the future money is worth today) by applying some sort of discount rate (often the benchmark interest rate of the country the company is based in).
As you might expect, discounted cash flow valuation models work best on businesses that have stable and predictable future cash flows. In his book "Investment Valuation," New York University Stern School of Business Professor Aswath Damodaran identifies a number of specific instances in which the discounted cash flow model starts to run into some difficulties.
Companies in trouble
Distressed businesses are often not cash flow positive, in which case it makes no sense to base valuation on them. The threat of bankruptcy in particular makes it even more tricky to project into the future. Even if this is a temporary setback for the company, making assumptions about cash flows that may never materialize is quite speculative.
Cyclical companies
Cyclical stocks, by their very nature, rise and fall with the ebbs and flows of the broader economy. For these businesses, performing a discounted cash flow analysis is complicated by the fact that no analyst can reliably predict when the macroeconomic conditions of any given country will change. Of course, most businesses are, to a certain extent, dependent on the broader economy; however, for cyclicals this is even more true.
Companies with unutilized assets
Valued on a cash flow basis, a business that has a large number of unproductive assets will have a lower valuation - all other things being equal - than a similar company that puts its assets to good use. This doesn’t mean that a discounted cash flow analysis cannot be applicable in this case - but it does mean that the analyst needs to externally account for the value of the non-productive assets. This logic extends to businesses that hold patents or licenses that do not currently generate any cash flows, but are still valuable.
Companies involved in acquisitions
There are two key problems with companies going through the merger and acquisition process, which Damodaran summarizes this way:
“The first is the thorny one of whether there is synergy in the merger and how its value can be estimated. To do so will require assumptions about the form the synergy will take and its effect on cash flows. The second, especially in hostile takeovers, is the effect of changing management on cash flows and risk and should be incorporated into the estimates of future cash flows and discount rates and hence into value.”
As with bankruptcies, it's hard to forecast future cash flows when the company in question is undergoing drastic changes.
Read more here:
- Aswath Damodaran: 3 Myths About Valuation
- Bill Ackman Reflects on J.C. Penney Failure
- Seth Klarman: Investors Are Like Relief Pitchers
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