How DCF Valuation Incorporates Economic Principles

How DCF Valuation Incorporates Economic Principles

One of the reasons why 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰 is a popular way to value businesses is how it incorporates solid economic principles. This method helps us value different business types, from young startups to declining to cyclical and commodity companies.

The 𝘁𝗲𝗿𝗺𝗶𝗻𝗮𝗹 𝘃𝗮𝗹𝘂𝗲 𝗶𝗻 𝗗𝗖𝗙 often accounts for a large part of the value compared to forecasted cash flows during the forecast period because cash inflows in the forecasted period get offset by cash outflows of CAPEX and working capital. Thus, the growth and competitive advantage taper as companies mature, reaching a stable phase.

Terminal value = (EBIT(1-tax)(1-g/ROIC))/(WACC-g)

At a stable period, ROIC = WACC.

Terminal value = EBIT*(1-Tax)/WACC

𝗚𝗿𝗼𝘄𝘁𝗵 𝗶𝗻 𝗜𝗻𝗳𝗹𝗮𝘁𝗶𝗼𝗻
I have observed analysts discount terminal value at a real inflation rate instead of a nominal rate during higher inflation.

𝗔𝘀 𝗽𝗲𝗿 𝗮𝗻𝗮𝗹𝘆𝘀𝘁𝘀 ->Terminal value = EBIT*(1-tax)/(WACC-g)

Terminal value = (EBIT(1-tax)(1-g/ROIC))/(WACC-g)

The analysts assume that g/roic = 0 -> ROIC is infinity, and the company grows without reinvestment.

The above assumption is erroneous as analysts assume growth without reinvestment. In addition, due to depreciation, the firm needs to replace its existing CAPEX with new CAPEX during inflation.

In my view, 𝐝𝐮𝐞 𝐭𝐨 𝐬𝐮𝐜𝐡 𝐮𝐧𝐫𝐞𝐚𝐬𝐨𝐧𝐚𝐛𝐥𝐞 𝐚𝐬𝐬𝐮𝐦𝐩𝐭𝐢𝐨𝐧𝐬, analysts often resort to valuing companies using multiples.

𝙃𝙤𝙬𝙚𝙫𝙚𝙧, 𝙖 𝘿𝘾𝙁 𝙫𝙖𝙡𝙪𝙖𝙩𝙞𝙤𝙣 𝙖𝙥𝙥𝙡𝙞𝙚𝙙 𝙘𝙤𝙣𝙨𝙞𝙨𝙩𝙚𝙣𝙩𝙡𝙮 𝙬𝙞𝙩𝙝 𝙩𝙝𝙚 𝙛𝙪𝙣𝙙𝙖𝙢𝙚𝙣𝙩𝙖𝙡𝙨 𝙤𝙛 𝙫𝙖𝙡𝙪𝙚 𝙘𝙧𝙚𝙖𝙩𝙞𝙤𝙣 𝙞𝙨 𝙨𝙩𝙞𝙡𝙡 𝙩𝙝𝙚 𝙗𝙚𝙨𝙩 𝙬𝙖𝙮 𝙩𝙤 𝙫𝙖𝙡𝙪𝙚 𝙖𝙣𝙮 𝙗𝙪𝙨𝙞𝙣𝙚𝙨𝙨 𝙧𝙞𝙜𝙝𝙩𝙡𝙮.