How DCF Valuation Incorporates Economic Principles

How DCF Valuation Incorporates Economic Principles

One of the reasons why ๐ƒ๐ข๐ฌ๐œ๐จ๐ฎ๐ง๐ญ๐ž๐ ๐‚๐š๐ฌ๐ก ๐…๐ฅ๐จ๐ฐ 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 ๐˜๐—ฒ๐—ฟ๐—บ๐—ถ๐—ป๐—ฎ๐—น ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ ๐—ถ๐—ป ๐——๐—–๐—™ 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 advantageย taper as companies mature, reaching a stable phase.

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

At a stable period, ROIC = WACC.

Terminal value =ย EBIT*(1-Tax)/WACC

๐—š๐—ฟ๐—ผ๐˜„๐˜๐—ต ๐—ถ๐—ป ๐—œ๐—ป๐—ณ๐—น๐—ฎ๐˜๐—ถ๐—ผ๐—ป
I have observed analysts discount terminal value at a real inflation rate instead of a nominal rate during higher inflation.

๐—”๐˜€ ๐—ฝ๐—ฒ๐—ฟ ๐—ฎ๐—ป๐—ฎ๐—น๐˜†๐˜€๐˜๐˜€ ->Terminal value =ย EBIT*(1-tax)/(WACC-g)

Terminal value =ย (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, ๐๐ฎ๐ž ๐ญ๐จ ๐ฌ๐ฎ๐œ๐ก ๐ฎ๐ง๐ซ๐ž๐š๐ฌ๐จ๐ง๐š๐›๐ฅ๐ž ๐š๐ฌ๐ฌ๐ฎ๐ฆ๐ฉ๐ญ๐ข๐จ๐ง๐ฌ, analysts often resort to valuing companies using multiples.

๐™ƒ๐™ค๐™ฌ๐™š๐™ซ๐™š๐™ง, ๐™– ๐˜ฟ๐˜พ๐™ ๐™ซ๐™–๐™ก๐™ช๐™–๐™ฉ๐™ž๐™ค๐™ฃ ๐™–๐™ฅ๐™ฅ๐™ก๐™ž๐™š๐™™ ๐™˜๐™ค๐™ฃ๐™จ๐™ž๐™จ๐™ฉ๐™š๐™ฃ๐™ฉ๐™ก๐™ฎ ๐™ฌ๐™ž๐™ฉ๐™ ๐™ฉ๐™๐™š ๐™›๐™ช๐™ฃ๐™™๐™–๐™ข๐™š๐™ฃ๐™ฉ๐™–๐™ก๐™จ ๐™ค๐™› ๐™ซ๐™–๐™ก๐™ช๐™š ๐™˜๐™ง๐™š๐™–๐™ฉ๐™ž๐™ค๐™ฃ ๐™ž๐™จ ๐™จ๐™ฉ๐™ž๐™ก๐™ก ๐™ฉ๐™๐™š ๐™—๐™š๐™จ๐™ฉ ๐™ฌ๐™–๐™ฎ ๐™ฉ๐™ค ๐™ซ๐™–๐™ก๐™ช๐™š ๐™–๐™ฃ๐™ฎ ๐™—๐™ช๐™จ๐™ž๐™ฃ๐™š๐™จ๐™จ ๐™ง๐™ž๐™œ๐™๐™ฉ๐™ก๐™ฎ.



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