Corporate Financial Management
Section A
One of the most common criticisms of DCF models is that any forecast beyond a couple of years is questionable. Investors, therefore, are alleged to be better off using more certain, near-term earnings forecasts.
Such reasoning makes no sense, for at least two reasons. First, a key element in understanding a business’s attractiveness involves knowing the set of financial expectations the price represents. The market as a whole has historically traded at a price-to-earnings multiple in the mid-to-high teens. Simple math shows today’s stock prices reflect expectations for value-creating earnings and cash flows many years in the future.
The mismatch between a short forecast horizon and asset prices that reflect long-term cash flows leads to the second problem: investors have to compensate for the undersized horizon by adding value elsewhere in the model. The prime candidate for the value dump is the continuing, or terminal, value. The result is often a completely non-economic continuing value. This value misallocation leaves both parts of the model—the forecast period and continuing value estimate—next to useless.
Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple.
Many companies require over ten years of value-creating cash flows to justify their stock prices. Ideally, the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance.
While the range of possible outcomes certainly widens with time, we have better analytical tools to deal with an ambiguous future than to place an uncertain multiple on a more certain near-term earnings per share figure. We address the uncertainty issue below.
In reference to the hostile bid of €694 million, what the free cash flow model tells us is that the company is valued around
One of the most common criticisms of DCF models is that any forecast beyond a couple of years is questionable. Investors, therefore, are alleged to be better off using more certain, near-term earnings forecasts.
Such reasoning makes no sense, for at least two reasons. First, a key element in understanding a business’s attractiveness involves knowing the set of financial expectations the price represents. The market as a whole has historically traded at a price-to-earnings multiple in the mid-to-high teens. Simple math shows today’s stock prices reflect expectations for value-creating earnings and cash flows many years in the future.
The mismatch between a short forecast horizon and asset prices that reflect long-term cash flows leads to the second problem: investors have to compensate for the undersized horizon by adding value elsewhere in the model. The prime candidate for the value dump is the continuing, or terminal, value. The result is often a completely non-economic continuing value. This value misallocation leaves both parts of the model—the forecast period and continuing value estimate—next to useless.
Some investors swear off the DCF model because of its myriad assumptions. Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple.
Many companies require over ten years of value-creating cash flows to justify their stock prices. Ideally, the explicit forecast period should capture at least one-third of corporate value with clear assumptions about projected financial performance.
While the range of possible outcomes certainly widens with time, we have better analytical tools to deal with an ambiguous future than to place an uncertain multiple on a more certain near-term earnings per share figure. We address the uncertainty issue below.
In reference to the hostile bid of €694 million, what the free cash flow model tells us is that the company is valued around
References: Arnold, G. (2008) Corporate Financial Management, Financial Times Prentice Hall McGuigan, J. , Kretlow, W. , & Moyer, C. (2009) Contemporary Corporate Finance, South-Western CENGAGE Learning Lumby, S. , Jones, C. (2011) Corporate Finance Theory & Practice, South-Western CENGAGE Learning Megginson, W. , Smart, S. , & Lucey, B. (2008) Introduction to Corporate Finance, South-Western CENGAGE Learning Brealey, R. , Myers, S. , & Marcus, A. (2001) Fundamentals of Corporate Finance, McGraw-Hill Irwin Fraser-Sampson, G. (2011) No Fear Finance, Kogan Page