Abstract
The Discounted Cash Flow (DCF) method is probably the most extended approach used in company valuation, its main drawbacks being probably the known extreme sensitivity to key variables such as Weighted Average Cost of Capital (WACC) and Free Cash Flow (FCF) estimations not unquestionably obtained. In this paper we propose an unbiased and systematic DCF method which allows us to value private equity by leveraging on stock markets evidences, based on a twofold approach: First, the use of the inverse method assesses the existence of a coherent WACC that positively compares with market observations; second, different FCF forecasting methods are benchmarked and shown to correspond with actual valuations. We use financial historical data including 42 companies in five sectors, extracted from Eikon-Reuters. Our results show that WACC and FCF forecasting are not coherent with market expectations along time, with sectors, or with market regions, when only historical and endogenous variables are taken into account. The best estimates are found when exogenous variables, operational normalization of input space, and data-driven linear techniques are considered (Root Mean Square Error of 6.51). Our method suggests that FCFs and their positive alignment with Market Capitalization and the subordinate enterprise value are the most influencing variables. The fine-tuning of the methods presented here, along with an exhaustive analysis using nonlinear machine-learning techniques, are developed and discussed in the companion paper.
Highlights
Estimating the fair price of a company or the Enterprise Value (EV) is a major issue in academic and business literature, as it has relevant impact in a number of situations
With the aim of evaluating the behavior of key variables of Discounted Cash Flow (DCF) model, we first scrutinized the existence of applying an effective Weighted Average Cost of Capital (WACC) for each sector, market, and region that fit the model by matching the EV through different systematic cash flow forecasting methods
Two relevant conclusions arise from this analysis: First, Free Cash Flow (FCF) forecasting strategies using polynomial fitting are consistently offering better results in modeling companies’ valuation; second, it is possible to obtain a WACC that fits every single company and year, and this figure could eventually be persistent in certain companies over the years
Summary
Estimating the fair price of a company or the Enterprise Value (EV) is a major issue in academic and business literature, as it has relevant impact in a number of situations. Sci. 2020, 10, 5875 this objective focusing in public companies, for which a large amount of information and knowledge is available. This working line conveys the development of tight tailored models, with relevant chances to overfit the selected target, and subsequently lacking generalization capability over time, sector, market, or region. In this category we can include the investment banks’ Investor Research (IR)
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