Mistakes in Discounted Cash Flows (DCF)

Mistakes in Discounted Cash Flow! How much can it affect your analysis? The answer is a bit YES! Yes, we make Valuation models, but are we 100% correct? Even small mistakes can hugely affect your analysis.

So let’s try to decode some major mistakes in discounted cash flow analysis. In this article, we discuss the following –

• Infographics: Snapshot of Steps to DCF Analysis
• Impact of DCF Mistakes
• Mistake#1-Forecast Horizon: Too Much or Too Less!
• Mistake#2-Cost of Capital: A Challenge?
• MIstake#3-Growth Rate Assumptions: Extreme?
• Other Errors
  • Unbalanced assumed investment and earnings growth.
  • Other liabilities: Inappropriate considerations
  • Changes in Numbers
  • Double counting the values
  • Real and Nominal Cash Flows
  • Understanding the Market Conditions
  • Tax rate errors

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Before directly jumping to the list of mistakes, the following are the infographics that highlight all important steps to DCF Analysis. This is just to brush up some important terms in DCF analysis. This will help you while we are looking at the mistakes in the further part.

DCF Infographics: Steps by Step Analysis

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Ok, so moving forward to our main topic of discussion.

 

What can be the impact of mistakes in discounted cash flow analysis?

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To know this, I have performed a “Two” DCF analysis of the same company.

• Analysis 1: No Mistakes in Discounted Cash Flow
• Analysis 2: Mistakes in Discounted Cash Flow

If you compare these two analyses, there are small changes deliberately made in certain values. This will help us to know the impact of Mistakes on the Intrinsic share price and BUY/SELL recommendation

Following is my final output from the Discounted Free Cash Flow Analysis. Check out the difference in the share price.

You can download the excel sheet containing formulas and calculations for with and without mistakes discounted cash flow analysis.

Mistakes in DCF

#1 No Mistakes in Discounted Cash Flow

#2 Mistakes in Discounted Cash Flow

#Mistake: Getting a Sell recommendation in spite of a strong Buy!

This is how the recommendation analysis works.

• It’s a BUY Recommendation, when: Intrinsic Share Price > Current Market Price (is Greater than)
• It’s a SELL Recommendation, when: Intrinsic Share Price < Current Market Price (is Less than)

In our case, Results were as follows:

• No Mistakes in Discounted Cash Flow gave a BUY Recommendation as = Intrinsic Share Price > Current Market Price, as 1505 > 1153

• Mistakes in Discounted Cash Flow gave a SELL Recommendation as Intrinsic Share Price < Current Market Price, as 418 < 1153.

You must be curious about which mistakes did I make? How are the Intrinsic Values differing so much? Now, presenting the mistakes that I deliberately made in the Discounted Cash Flow Analysis. Let’s analyze them one by one.

1. Forecast Horizon: Too Much or Too Less!
2. Cost of Capital: A Challenge?
3. Growth Rate Assumptions: Extreme?

DCF Mistake#1 – Forecast Horizon: Too Much or Too Less!

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Consider that you are valuing an FMCG based company. But you perform financial projections for only two years. Do you think that it is the right approach? Definitely not!

A time frame of at least five to seven years needs to be considered while performing DCF analysis. But this does not mean that you consider the time frame of 50 years, that would be absolutely wrong.

Imagine the interest rates, economic factors, inflation after 50 years! And we do not have any financial superpower to predict the same. So from now on, for each of the mistake we will list down specific values taken for:

Forecast Horizon – Without Mistakes

We have considered the forecast period of 5 years for the analysis.

Forecast Horizon – With Mistakes

• Forecasting is done only for a period of 2 years.

Considering a short forecast period does not give you the effect of different parameters in the coming years. It largely affects the intrinsic share price.

Hence it is essential to take a proper explicit period that is not too short or not too long.

DCF Mistake#2 – Cost of Capital: A Challenge?

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Many DCF modes are built on the non-sensible cost of capital. This is one of the major mistakes in Discounted Cash Flow.

Here is the reason why.

• Most companies use either debt or equity for financing their operations.
• The cost of the debt part for large companies is usually transparent as they have to make contractual obligations by the way of coupon payments.
• But estimating the cost of equity is more challenging.
• Because unlike debt’s explicit cost, the cost of equity is implicit.
• Also, the cost of equity is usually higher than the cost of debt as equity’s claim is junior. And no simple method exists to estimate the most accurate cost of equity.
• By far the most common and used approach for estimating the cost of equity is the capital asset pricing model (CAPM).
• According to CAPM, the company’s cost of equity is equal to the risk-free rate plus the product of the equity risk premium and beta.
• Government-issued bonds generally provide a good representation of the risk-free rate. But estimating the equity risk premium and beta proves to be much more challenging.

We will now analyze the effect of two important considerations of the CAPM, in our analysis: Beta & Equity Risk Premium

#1 Beta:

This is what Beta is:

• Beta reflects the sensitivity of a stock’s price movement relative to the broader market.
• A beta of 1 suggests that the stock tends to move in line with the market.
• A beta below 1 means that the stock moves less than the market.
• A beta above 1 implies that the stock moves greater than the market.
• Beta, though it sounds wonderful in theory, it fails practically and empirically.
• Ideally, we want forward-looking betas, which is difficult to estimate reliably.
• Beta’s empirical failure shows how beta does a poor job explaining returns.

Beta Value – Without Mistakes:

• We have taken the Beta value from a trusted source reuters.com.
• In our case, the beta value fetched from Reuters for the company is 0.89

Beta Value With Mistakes:

• The beta value is randomly considered.
• Thus the Beta Value in this case is 1.75.

#2 Equity Risk Premium:

• The second important input of CAPM which can cause errors is the equity risk premium.
• Like the Beta, the equity risk premium is a forward-looking estimate.
• Relying on past equity risk premium values, may not give a reasonable sense of the return outlook.
• Research also suggests that the equity risk premium is possibly non-stationary.
• Thus using past average values can be very misleading.

Equity Risk Premium – Without Mistakes:

Understand the following:

• The risk-free rate is the rate of return on your investment with no risk and no loss.
• Generally, the Government Bond rate is considered in this case.
• Search and you will easily get the risk free rate value for the Government bond.
• The Indian Government Bond rate that I fetched was 7.72%.
• As an investor in the Stock Market, the general expectation is to get more returns than the risk-free rate.
• Let’s consider the return expectations between 10%-15%.

According to the Capital Asset Pricing Model, the Formula for calculating the required rate of return is:

=Rf + β(Rm-Rf), Where,

• Rf is the risk-free rate
• β is the Beta Value
• (Rm-Rf) is the equity risk premium

So if the investor is expecting 12% returns, let’s see how the values will fit in our formula:

To make the LHS equal to RHS:

12%= 7.72%+0.89*(?)

(?)= 4.81

Thus the equity risk premium, in this case, is 4.81

Assuming a percentage in the range of 4.5%-5.5% may give you the proper value.

In our correct analysis, I have taken the equity risk premium of 5%.

Equity Risk Premium – With Mistakes:

• Equity risk premium is randomly considered.
• Thus the Value, in this case, is 8%.

Growth Rate Assumptions: Extreme?

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• Consider yourself as an insurance agent. You are able to get many customers; you have overachieved your targets. But how?
• By promising the clients aggressive returns of 30%, with a surety of cumulative increase each year.
• You were able to fool the clients but can you fool yourself?
• You cannot guarantee your clients with some extreme growth figures. Things do not work like that.
• You have to take into account all the possible factors that affect the growth rate.

The same is the case when you build your DCF model.

Generally, the long term growth rate assumptions are taken wrong. These assumptions are taken to determine the terminal value component of the DCF valuation.

You have to bear in mind that, long-term rate of growth should not exceed the sum of inflation and real GDP growth at the most.

Growth Rate – Without Mistakes:

• Growth rate assumptions should always be considered less than the country’s GDP.
• Taking this into consideration, I have taken the growth rate to 5%. (Less than India’s GDP, which is in the range of 7%)

Growth Rate – With Mistakes:

Extreme Growth percentage of 8% assumed. (More than the GDP growth rate).

These are some common mistakes made in the discounted cash flow analysis. This will help us to analyze the extent of differences in the values. So let’s sum up the differences in our Analysis. These are the results that we got:

Intrinsic share price

• With Mistakes: 418
• Without Mistakes: 1505

 

BUY/SELL recommendation

• With Mistakes: SELL
• Without Mistakes: BUY

 

Difference in the values from the actual analysis

=(1505-418)/1505 = 72% (HUGE!)

Apart from these above-stated mistakes, we have some other common errors as listed below:

1. Unbalanced assumed investment and earnings growth.
2. Other liabilities: Inappropriate considerations
3. Changes in Numbers
4. Double counting the values
5. Real and Nominal Cash Flows
6. Understanding the Market Conditions
7. Tax rate errors

The above list is taken from  http://www3.nd.edu/

#1 Unbalanced assumed investment and earnings growth.

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• Companies invest in the business via working capital, capital expenditure, acquisitions, R&D, etc.
• All these steps are taken in order to grow over an extended period.
• Return on investment (ROI) helps in determining the efficiency with which a company translates its investments into earnings growth.
• Since ROI is linked to investment and growth, investors must treat the relationship between investment and growth carefully.
• DCF models can sometimes underestimate the investment necessary to achieve an assumed growth rate.

The source of this mistake is as follows:

1. For Companies that have been highly acquisitive in the past, Analysts consider the same growth rate now, even if the company is not that much into acquisitions.
2. One can overcome this mistake by carefully considering the growth rate that is likely to come from today’s business.

#2 Other liabilities: Inappropriate considerations

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Another mistake in Discounted Cash Flow is with respect to other liabilities.

• Corporate Value is determined based on the present value of future cash flows.
• Cash and any other non-operating assets are added while debt and any other liabilities are subtracted to arrive at shareholder value.
• Some other liabilities, like employee stock options, are trickier and more difficult to analyze. Thus most analysts do a very poor job analyzing these liabilities.
• At the same time, some liabilities are most common in some sectors.
• For example, post-retirement employee benefits plans are more common in manufacturing industries while employee stock options occur most frequently in service industries.
• Hence investors must properly categorize and recognize other liabilities in the sectors where they may have a large impact on corporate value.

Also, check out Restricted Stock Units

#3 Changes in Numbers

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• Sometimes small changes in assumptions can also lead to large changes in the value.
• Investors should also look to the value drivers like sales, margins, and investment needs as sources of variant sensitivity.

#4 Double counting the values

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• Always make sure that your model does not get into the mistakes of double counting. Now you must be wondering what exactly is double counting. So let’s understand it in simple terms.
• Double counting simply means that some values are taken twice, causing errors in the model.
• Your intrinsic share price changes by considering the values twice.
• Double counting can also take place while considering the risk factor.
• There are two ways of taking into account the uncertainty of the future:

1. Directly adjusting the cash flows in the model.
2. Considering a discount rate.

• Hence if adjustments are made in both the above methods, it can lead to double counting of the risk thus leading to an error.

#5 Real and Nominal Cash Flows

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Let’s understand the difference between real and nominal cash flows.

• Nominal: Cash flows that incorporate the effects of inflation
• Real: Cash flows that exclude its effects are on a real basis.
• Thus, where real cash flows are used, the impact of inflation needs to be considered in the discount rate.
• Often errors are seen here as no adjustments are made.

#6 Understanding the Market Conditions 

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• In some cases, income and operating statements for a particular project do not reflect normal operating patterns.
• Thus ultimately this will have an effect on your DCF model and the intrinsic share price.
• In such a case it is necessary to reconstruct the actual operating statements to reflect market conditions.
• Projected operating or income statements must attempt to reflect actual market conditions.

#7 Tax rate errors

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• A general mistake made: Adopting a tax rate that does not reflect the long term tax rate for the asset.
• In order to properly reflect expected future cash flows, forecasts should be based on the expected effective tax rate applicable at that time.
• It is essential to devote some time to analyze the corporate tax rate.
• Properly analyzing the tax rate and considering it in your model will surely bring it one step closer to perfection.

Other related valuation articles that you may like

• Insurance Agent vs Broker Differences
• What is the Effective Tax Rate Formula?
• Interpretation of the Equity Risk Premium Formula in CAPM
• What is the Intrinsic Value Formula?
• Calculation of Cost of Equity
• Calculation of Equity Value
• What is Discounted Cash Flow Valuation?
• Calculating PE Ratios
• Why Price to Book is used in Banks?
• Calculate EV and Equity Value

Mistakes in Discounted Cash Flows (DCF) Video

Conclusion

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Since you are now aware of all the probable things that can go wrong in DCF calculations, be well prepared. It is essential to ensure that the assumptions are economically sound as well as transparent. Even the slightest of change in assumptions in Cost of Capital, growth rates, etc can change the recommendation from BUY to SELL or vice-versa. Please remember that very few DCF models pass the NO MISTAKE DCF test.

Now that you have gained some insights into “Mistakes in Discounted Cash Flow”, I hope that your Analysis will stand apart. Happy Valuations!