How to Sanity Check Your DCF Analysis and Avoid the Top 3 Errors
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- čas přidán 27. 07. 2024
- Learn how to check your DCF analysis for the three most common errors in this lesson, including problems with the Terminal Value, the PV of the Terminal Value, and the double-counting of items. You will also see a demonstration of how you might fix a DCF and make the analysis more meaningful. breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"
Table of Contents:
1:50 The 3 Mistakes to Avoid in a DCF
7:07 How to Fix the Top Mistakes in a DCF
9:01 How to Fix Our DCF in Excel
15:41 Recap and Summary
Lesson Outline:
Common question: “I need your help. I didn’t get a chance to go over the entire course yet. I am working on a DCF (Discounted Cash Flow) model and need to make sure my model is error-free.”
“Are there any sanity checks I can do? Or any simple ways of making sure my model isn’t wrong?”
This is a difficult question to answer because there isn’t necessarily a “correct” answer to a financial model, or a “correct” way to build one.
However, there are definitely some common mistakes, especially in a standard analysis such as the DCF.
The Top Three Most Common Mistakes in a DCF
Problem #1: How much of the company’s Present Value comes from the PV of its Terminal Value?
If it’s 80-90%, you have a problem.
Ideally, it should be 50-60% or less, depending on the industry and the company’s maturity.
It’s not the end of the world if it’s 65%, but if it’s in the 80-90%+ range, there’s little point in even running a DCF analysis since so much of the value comes from the Terminal Value at the end.
Problem #2: Do the Implied Long-Term Growth Rate and the Implied Terminal Multiple make sense?
These should be in-line with the GDP growth rate or growth rate of the overall economy and the multiples of the public comps, respectively.
So if the long-term growth rate is 10% but the GDP growth rate is 3%, you’re in trouble, and you’re also in trouble if the implied multiple is 10x but the comps trade at 8x.
You generally want the implied long-term growth rate to come in below the GDP growth rate, and you generally want the implied multiple to be at or below the median multiple from the comparable companies, since multiples tend to decline over time as companies become more mature.
Problem #3: Are you double-counting items?
The rule is very simple:
If an item is included in FCF, leave out of the Implied Enterprise Value to Equity Value calculations at the end.
If an item is not included in FCF, keep it in the Implied Enterprise Value to Equity Value calculations at the end.
For example, with Interest Expense, if you leave it out (as in Unlevered FCF), you DO want to subtract debt at the end when moving from Enterprise Value to Equity Value.
On the other hand, if you leave it in, you’re calculating Levered FCF and you do NOT want to subtract debt at the end because you’re just calculating Equity Value, not Enterprise Value.
How to Fix These DCF Mistakes
Fix #1: Extend the projection period to 10-15 years instead, since 5 years is often too short.
Extending the projection period will often fix other problems as well, such as the long-term FCF growth rate being significantly different from FCF growth in the final year.
Some people will argue that 10-15 years is too long, but the truth is, management teams and executives make decisions based on long-term planning. No one will decide on a major initiative based on a desire to improve results over only a few years.
Fix #2: Reduce the Terminal Value by using a lower long-term growth rate or a lower terminal multiple.
If you use a multiple or a growth rate more in-line with the ranges recommended above, you’ll be more likely to get meaningful results in the analysis.
The company should never be growing faster than the economy as a whole into perpetuity.
Fix #3: Increase the Discount Rate, since it will impact the Terminal Value more in most cases and reduce the contribution from the PV of the Terminal Value.
While this fix can sometimes work as well, it is generally not a great idea because the Discount Rate DOES still impact the Present Value of Free Cash Flow as well.
So you may need a dramatically different Discount Rate to reduce the contribution from the Present Value of the company’s Terminal Value.
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This is the most helpful video I've learned from this week...I was able to fix my DCF thanks to your example. Thanks alot
+Mike Lim Thanks for watching!
Thanks Brian, I have a question though,
To calculate WACC we tend to assume the Capital Structure of the industry/comps which can be different from the current capital structure of that entity, so when we are to calculate implied Equity Value from implied TEV, should we add current Debt of the entity or the industry Debt of the industry/comps which we considered for WACC calculation?
Thanks. You don't normally do this because the DCF itself is still based on the subject company's current or expected capital structure. Only the Discount Rate is based on the comparable companies - because the argument there is that the company's actual risk and potential returns might be closer to those of the comps.
With the cash flow projections and Terminal Value, you're making a direct forecast based on the company's history and expectations, so there's no reason to link them to the comps.
I do not understand the double counting items ,would you please explain in writing so that I can read them throughtly.Thank you in advace for your kind help.
If you include an item that affects FCF, then you should not include its corresponding Balance Sheet item at the end in the Equity Value to Enterprise Value bridge. For example, the Interest Expense reduces FCF. Therefore, if you include the Interest Expense in the calculations, then you should NOT also include Debt at the end. But if you exclude Interest Expense, then you SHOULD include Debt in the bridge at the end.
Thx for your kind help.
From which case study/course is that? I mean, I would like to go through the whole thingy with the cost of capital, net debt, etc...
Excel & Fundamentals (breakingintowallstreet.com/biws/excel-financial-modeling-fundamentals/)
good video
Thanks for watching!
okay so i have a question, please can you tell me if the DCF model is impacted more from the initial years of cash flow or the later years of cash flow, and my answer to this is:
if the time period of the project is limited lets say 5 years then in this case initial years cash flow will have greater impact on the valuation because of there is high initial cash flow in the beginning cause of the higher growth rate in initial years and lower cash flow in later years cause of lower growth rate in later years, then the pv would be high and vice versa.
but if the project's time period is indefinite then the later years cash inflow would highly impact the valuation cause in this case we would have to use the terminal value of the project and if the project as lower cash inflow in the later years than it would have lower terminal value and hence low valuation.
am i right or please correct me if i am wrong
The initial cash flows should almost always impact the DCF by more than the later cash flows because of the time value of money. Money today is worth more than money tomorrow, end of story.
There is some nuance to this because of cases where the company does not generate any positive cash flow today / in the near-term, cases where cash flow spikes up suddenly in later years or declines, etc., so it is not quite that simple for all real-life scenarios, but at a high level, this question is testing your understanding of the time value of money.