The limits of DCF models and the need for alternative valuation methods

Figure 1. WeWork valuations. Reprinted from CNBC,
by A. Sherman, 2019, https://www.cnbc.com/

As the year 2019 is ending soon, it may be worth to take a look back on major events that happened on the international financial markets in the recent past. If I would ask investors what first came to their mind when recapping the incidents, surely many would come up with the WeWork case. In a summary, the telecommunication company SoftBank invested up to $10.65 billion (CNBC) in the loss-making office space renter start-up, leading to excessive value inflation that ended up with a $47 billion valuation in their most recent private funding round (FT). WeWork’s following IPO plans lastly collapsed under the scrutiny of the public markets, revealing the over-valuation and the tremendous misjudgement of financial analysts. But when it comes to incorrect valuations, WeWork’s case was not the only one in 2019. While the fitness equipment producer Peloton failed to convince it’s investors of their $8.2 billion (FT) valuation, trading at almost 15% below their offer price (FT) on the first trading day, the question that investors ask themselves at the latest since the crash of the Dotcom-Bubble, namely if there is any truth in financial valuations, is still a recent one.

Logically, if one doubts the correctness of financial valuations, one must doubt the commonly used valuation techniques which are mainly the discounted cash flow method (DCF) and the multiple analysis approach (Mukherjee, Kiymaz, & Baker, 2004). In the following, I want to shortly discuss uncommon points of critique on DCF models and give an overview of a strategic framework that can even be used by regular investors, in addition to traditional financial valuation.

First of all, when people criticise the use of discounted cash flow methods, they mostly see issues in the assumptions of static discount rates, inappropriate discount rates or the imprecise prediction of future cash flows, but never in the use of free cash flows itself. As there are no “perfect” markets in which companies only invest in positive NPV projects and return excess profit to their shareholders like Modigliani & Miller (1961) state in their residual dividend policy theory, it is questionable if the usage of free cash flow itself is an appropriate measuring unit. For example, 2 comparable companies that both have the same predicted future cash flows and discount rates should have the same valuation, even if one of both only spends its cash on increasing executive salaries and negative NPV projects while the other one is acquiring strategically suitable and highly efficient competitors. Taking this argument into consideration, the Dividend Discount Model would be a way more appropriate method of valuation as Dividends paid back to the shareholders can not be embezzled anymore, could one argue cynically.

Figure 2. Impact of WACC on Terminal Value. Reprinted from Financial Times,
by D. Keohane, 2016, https://www.ft.com/

A second DCF criticism that I want to highlight here is a highly topical one. Only a few years ago, not many people may have imagined that the base interest rate of several economically stable countries could be more or less zero, somehow even negative. This significant macroeconomically shift has a major impact on basic financial models like the capital asset pricing model and therefore also on DCFs. When the risk-free rate is approximately zero, WACC falls due to falling costs of equity. In this case, the anyhow hard to predict terminal value gets accountable for a higher proportion of the total NPV and therefore, a possible misjudgement has a greater impact on the total valuation. This issue is surely a commonly known one, although, investors and analysts should be aware of it as the impact of the terminal value and its faultiness is way greater than one could think.

Referring back to the recently unsuccessful valuations of WeWork and Peloton, it is not a secret that start-up valuations present the most complicated cases in practice. The simple reason for this is the lack of accounting information. Therefore, the state of the art academic research suggests shifting the focus from solely carrying out a financial valuation to taking into consideration modern frameworks of strategy theory. As Miloud, Aspelund & Cabrol (2012) suggest, modern start-up valuation should take place in the context of the structure of its market, stress out the firm’s valuable assets and inputs instead of possible future cash flows and examine the network and external relationships of the company. More precisely, statistically significant factors that correlate positively with the start-up valuation are I] Industry product differentiation, II] Industry growth, III] Founder with industrial experience, IV] Founder with managerial experience, V] Founder with start-up experience, VI] Team of founders, VII] Managerial key positions are filled, VIII] Number of alliance partners. The weak spot of the strategic framework is obvious: It always needs the so often and with justification criticised financial valuation. However, it provides an excellent benchmark for valuation if compared to peers that share general characteristics with your target and recently went public. Lastly, it has the same major benefit as discounted cash flow models: The investors or acquirer has to scrutinize the target as carefully as possible, has to be familiar with the business model and not only with the financials and therefore, he or she gets more and more of a personal feeling if the company may be the next unicorn or if it disappears within the next few years.

Professionals all over the world love the saying that “Valuation is an art, not a science” and, understandably, they repeat it as often as possible as it allows them to justify their mistakes. However, I think the saying is nonsense because art can never be judged as right or wrong while there definitely exists an unambiguous value for each existing company, we just often can’t tell what it is. I do not want to question the difficulty or complexity of business valuation but once again, I want to emphasize the importance of research on daily business as both should learn from each other instead of working in different worlds.

Bibliography
Miller, M. H., & Modigliani , F. (1961). Dividend policy, growth, and the valuation of shares. The Journal of Business, 34(4), 411-433.

Miloud, T., Aspelund, A., & Cabrol, M. (2012). Startup valuation by venture capitalists: an empirical study. Venture Capital, 14(2-3), 151-174.

Mukherjee, T. K., Kiymaz, H., & Baker, H. K. (2004). Merger motives and target valuation: A survey of evidence from CFOs. Journal of Applied Finance, 14(2).