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Using discounted cash flow for valuations

Discounted Cash Flow Calculator - is a tool to...Discounted Cash Flow Calculator - is a tool to help estimate the present value of a stream of free cash flows discounted to the present. (Photo credit: Wikipedia)

If you used or will be using DCF (Discounted Cash Flow) in the valuation of a company you may want to consider a recent federal bankruptcy court decision court (N.D. Ill.): the “wide” and “striking” disparity between experts “lends credibility to the concept that the DCF method is subject to manipulation and should be validated by other approaches.” In particular, that by taking a discretionary approach to DCF, “a skilled practitioner can come up with just about any value he wants.”

The court cited experts who begin with the same cash projections but end with values nearly $8 million apart for a relatively small, family-owned company. In this case, the experts’ disagreement largely came down to how each calculated the weighted average cost of capital (WACC) thereby impacting: the debt-to-equity ratio, the equity risk premium (ERP), and the size premium—as well as the terminal value. Each expert cited various models and experts to defend their points but “each expert generally selected parameters that pushed his valuation in the direction he wanted to go,” the court says.

The court ruling essentially fell back on “real world” evidence at the time of the company’s acquisition to find that it was solvent, including its lack of debt, its substantial cash in excess of working capital, and its ability to keep current on accounts payable.

Good Luck

Steve Sink, CBI, M&AMI

[email protected]

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