Discounted cashflow (DCF)
The principal purpose of Progressive research is to help investors understand how companies work and generate value, and we believe that in most circumstances a set of traditional DCF results will not make things significantly clearer to the reader. Hopefully this blog will explain why, but it is also a precursor to another blog on multiples-based valuation that sounds warning bells for anyone who regards multiples as being relatively free from manipulation.
Discounted cashflow has always been a controversial valuation methodology. On one hand it holds the promise of a theoretically correct price, but on the other it brings considerable room for error and, perhaps worse, the illusion of accuracy – providing an outcome that is precisely wrong.
Although producing a DCF can be a difficult and complex task, the basic principle behind it is quite simple. If I provide someone with cash now and get it back later, I want some reward for the risk, inconvenience, lost opportunity and any loss in purchasing power due to inflation – so I need to apply a discount to those future receipts.
The cashflows come in several main forms. We pay out at the start and perhaps subsequently to fund the investment/venture, then we may get dividends as we hold the investment itself and finally we get the price someone pays to buy the share from us.
An example DCF – ewidgets
The best way – and to be realistic the only way – to illustrate the value and the danger of a DCF is with an example.
Consider a company that makes ewidgets – like widgets but with the promise of changing the way we live our lives, whether we like it or not. This is a relatively young company and its best years are yet to come – many years away in fact, well beyond the three-year period covered by most equity research forecasts.
We start with a central case for ewidgets. Realistically, ewidgets are not going to take over the world, and after several years of 20%+ revenue growth and then several more of double digits, by the end of the company’s first decade revenue growth has slowed to 8% per annum. By this time the market has matured and ewidgets have a stable market share, and hence stable margins.
The DCF model assumes a payout of all surplus cash to shareholders and our assumptions look sensible, with the grossly simplifying assumptions that depreciation and amortisation equal capex and that there is no tax. We have assumed a cost of capital of 12.25%, discounting the income we get at the end of the first year by 12.5%, ie 89% of its nominal value then. We can be pleased with ‘knowing’ what the business is worth to the nearest pence per share, £3.85.
We can now examine the implications of a few changes to our central-case assumptions. But before that, it is worth looking at where the value of this £3.85 per share lies over time. How much of the value lies in the next five years, the five years after that and then onwards. Just 12% of the value lies in the first five years – the bit we have vague clue about. Then 32% lies in the next five years, with the remaining 56% beyond the decade horizon.
So what happens if we tweak a variable like margins?
Our central case has a ‘good’ 50% gross margin and by the end of the decade operating margins have stabilised at an equally ‘good’ 15%. But it is surely not unreasonable to consider that a 52% gross margin might be achieved and perhaps that this management team might just work away on operating costs by 1% of revenues. These small changes lead to a 24% increase in the DCF share price to £4.95.
Of course, it is just as easy to suggest that ‘good’ margins are too optimistic for a market and that operating cost pressures are everywhere. A 2% knock to gross margins and 1% of slippage (in revenue terms) on operating costs takes the DCF share price back to £2.79.
In the context of a moot conversation in Year 0 among potential investors about the prospects for this young company over the next decade, each of these ‘small’ variations is unlikely to garner much more than a ‘meh’ and very unlikely to lead to a heated debate.
However, the difference of two ‘mehs’ on two basic income statement assumptions has given rise to a range of over half the central-case value!
What about the cost of capital?
As highlighted at the start of this blog, as well as the cashflows themselves, the ‘cost’ we charge for the risk and delay in their receipt is significant.
We have applied a cost of capital of 12.5% for this business. This equates to a risk-free rate of 3.5%, an equity risk premium of 6% and a Beta for ewidgets of 1.4. In simple terms, the Beta is a measure of the risk of the stock versus the market measured over time, and it is applied to the risk associated with being invested in the stock market to get to the overall risk of the investment (according to the Capital Asset Pricing Model at least). For most well-established companies with share price track records, it is a relatively sensible measure to take – easily obtained from the likes of Bloomberg or Eikon. For earlier-stage companies, those with recent, current or prospective balance sheet restructurings or companies that are under periods of fundamental change, it is a far less reliable measure. For active small and mid-cap investors, of course, that’s exactly the sort of company they are looking for.
If we don’t have a Beta for our company, we can perhaps draw upon the Betas for similar companies and make some adjustments (long story, not now…) or we can cop out with the assumption that it will be like the market as a whole (Beta=1.0). Here are a few well-known UK-listed companies and their Betas (Refinitiv, June 2023).
Here again we can look to our moot investor conversation about the prospects of ewidgets and consider the potential investors. Having slogged their way through considerations of the business model, the competitive environment, the technology, the management team bios and the financial model, they may be only a ‘whatever’ away from dropping the 1.4 Beta and accepting a Beta of 1.0 (like the market as a whole) or alternatively from declaring ewidgets as being as ‘risky’ as ITV or Rolls-Royce and applying a Beta of 2.0.
The impact on the share price central-case DCF is that with a Beta of 1.0 and a WACC of 9.75 it yields a share price of £5.39, while with a Beta of 2.0 and a WACC of 16.0% it yields a share price of £2.53 – a range of £2.86.
Combining the ‘mehs’ (margins and costs) with the ‘whatevers’ (Betas) can yield a low share price of £1.80 and a high of £6.87 – that’s a range greater than the initial share price estimate.
It is quite clear that whilst I can start with a DCF valuation of £3.85 and give strong and valid reasons for my assumptions, it is quite preposterous to say that £3.85 is the right price or that DCFs tell us what an investment is really worth.
But we should not write off the DCF as a tool just yet. It does not provide the precision that some ascribe to it, but it can provide a ball-park figure and that can be the starting point for a sensible consideration of what the current share price might imply about the market’s understanding and expectations.
That said, it would be naïve to assume that multiples-based approaches are immune to such manipulation. Far from it, in fact. As we will examine in a future post, there are a number of ways that P/E and EV/EBITDA multiples can be distorted or massaged to reach more palatable conclusions.
Ian Robertson
irobertson@progressive-research.com
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