Why do we build a Discounted Cash Flow (DCF) Model

Damodaran on Valuation by Aswath Damodaran
Must Read Book on Valuation
There is a lot of literature on the web explaining the importance of a DCF model and how to build one. However, as I recently realized, not many companies are focused or care enough to build an effective cash flow model to evaluate an investment. The fact that these are large corporations borrowing heavily from Wall Street makes it a matter of concern.

The fast pace of decision making in a demanding high growth technology based world has forced companies to bank on experience and/or gut feeling to make an investment. Although, this is in effect not a bad way to run a business in a highly competitive industry such as e-commerce for example, there is still what I call a “responsibility” towards adding more reasoning for strategic investments. The main reason being that the money that a company spends on its investments or excesses is actually money borrowed from investors who are expecting a return on their investment. Greedy- yes, but so is the way capitalism works.

So, when a company decides to make use of the money, they got to have a better reason as to what returns that will produce. This should go above and beyond rosy statements on what this strategy means for the company. The only way this can be done is by adding the language of finance to a strategy. This is where the discounted cash flow analysis comes into the picture. There are several other ways in which a financial analysis of an investment can be made to judge if it is sound in its fundamentals. One can look at top line or bottom line numbers and still feel comfortable about what they are getting into. The big winner among them however has been the DCF approach. Simply speaking, it goes a step further from just a limited accounting analysis and does what can be the best theoretical approach to determining a discount rate (cost of capital).

When I did my MBA, I had a hard time understanding these concepts as I was a slow convert to the field of finance. It was not until I joined my company post my MBA that I started exploring these concepts in detail. Anyways, in short, the DCF does some pretty simple and basic steps to arrive at what is called as a “Free Cash Flow” – as the term suggests, it is cash that is available for the company after it has factored for all costs related to an investment.

Starting with the sales an investment generates, we get to the EBITDA, do a small manipulation with the DA portion (Depreciation and Amortization) by including it for tax purposes and removing it for cash flow purposes, and adjust for working capital and other capital gains. In effect, once all these are meticulously done, we get to what is called as an “incremental free cash flow”. This figure is what makes a DCF model better than just a simple accounting practice of arriving at the Net Income. Cash Flow is a much realistic estimate of what the company truly has in its hands after generating the required money for an investment. If the FCF is negative for a prolonged period of time, it in effect indicates that something may be wrong with the investment. Now, once the company has say $10,000,000 of cash, it now has an obligation to its investors that it needs to fulfill. Ideally speaking, it has more of a direct obligation to pay for its leveraged debt than for its equity, but in a ideal scenario, equity investors or share holders do expect some money for the shares they hold in the company.

So, there is where the discount rate comes into the picture. The discount rate is applied by using compounding on the FCF over the number of years that the investment is expected to produce sound returns. Compouding is simply used as laws of greediness dictate that money earned today is used to make more money tomorrow. So, the interest will also be invested to generate more money. The discount rate as such is also called as the “cost of capital” – the reason being that the capital (money) that a company gets has a corresponding cost (investor return) attached to it that the company needs to pay out. DCF model relies on what is called as the WACC (Weighted Average Cost of Capital) to arrive at this discount rate.

The WACC is a weighted average as it uses the D/E ratio to arrive at what portion of the discount rate (or investor return) is attributed to the debt holders and the share holders. The laws of capital markets dictate that the debt holder has the first right towards returns and then comes the share holder (provided there is anything left to give them). The debt portion is for a very funny (or greedy) reason tax deductible. Hence, it is dealt with in a different manner. The equity part of the discount rate is determined using what is called as the CAPM. A Nobel prize winning concept, it is fairly simple to understand but complicated to derive. Nevertheless, it looks into the performance of the company in the market to determine what returns the company can provide. CAPM has its own set of limitations as does the DCF model or any other financial analysis for that matter. No matter what, the discount rate or WACC eventually is applied on the FCF to determine what remains in terms of cash for the company after paying for all its obligations.

DCF model can be manipulated to suit the needs of the person building the model. This is where subjectivity in assumptions, a lack of conviction on part of the person building the model, the desire for glory on part of management to prove that their decisions are always right comes into the picture. These human interventions can in turn affect the “truth” of the model. Many people in the place I’ve worked claim these to be the reasons why there is no point in wasting time building such complicated mechanisms. In other words, it is a safe way to put ones inhibitions and fears on the backburner, for who wants to embarrass themselves by working on tough financial models. After all, nobody is truly judged for performance based on what they do to run a business, it is the money they generate that matters.

Then comes the NPV to make quick decision based on the DCF analysis. NPV or Net Present Value is just a way of deriving the “time value of money” of the entire investment. By bringing all the money a company makes to year 0 (starting year of investment) and subtracting it from the initial capital investment for a project, a number shows up that indicates what is the prevent value of all the money a company makes in the future on that project. The number has to be positive as if it isn’t, it indicates that the investment made is not generating the required returns.

This is the DCF in short. The reason why it is important to have belief in the model and make a sincere attempt at using it is to make a relatively better objective evaluation of an investment. If greed and glory are overcome, a bad investment or negative NPV will be readily defended by a financial analyst to prevent the company from making the investment. Unfortunately, it also needs a strong commitment on the part of the largely ignored and demoralized financial analyst to face the outcome of his/her recommendation. After all, life is not fair. The DCF model may have said something but the fickle minded consumers who eventually utilize the benefits of an investment may think otherwise. The company may not make the $10,000,000 that they desired to make and the DCF analysis is to be blamed!

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