Abstract
Valuation based on DCF (Discounted Cash Flow) has been the dominant valuation procedure during the last decades. In spite of this dominance, enterprise valuation using the discounted FCF (Free Cash Flow) model has some practical drawbacks, since there is often some confusion on how to effectively use it. Commonly, the valuation procedures start by estimating future FCF figures from historical data, such as mean FCF, growth and retention ratio, alongside many other variables. These FCF forecasts are discounted at the cost of equity (FCFE – FCF to Equity) or the Weighted Average Cost of Capital WACC (FCFF – FCF to Firm). Implicit in the above mentioned valuation procedures is the expectation that the company puts the retained free cash that is generating to good use, yielding a value capable of rewarding appropriately the level of risk inherent in the way it used. Some poorly performed valuation studies however tend to double count (Damodaran, 2006a) the retained cash’s interest in subsequent values of FCF, or include the accumulated cash build-up in the Terminal Value. This paper discusses how these two common double-counting mistakes are made and evaluates their weight in the final valuation figure for the particular case of retained FCFE (the case for the FCFF is analogous, but we focus on FCFE for simplicity) using projected figures.
Highlights
The essence of discounted cash flow valuation is simple; the asset is worth the expected cash flows it will generate, discounted to the reference date for the valuation exercise
All these models were prone to double-counting (Penman & Sougiannis (1997) described that ―discounting earnings as if they were cash flows paid out to stockholders while counting the growth that is created by reinvesting those earnings will lead to the systematic overvaluation of stocks‖), something that was discussed in Glassman & Hassett (2000)
Since we discount FCFE at the cost of equity re, the earnings from retention of the FCFE that sometimes are incorrectly included in the following year’s FCFE must be discounted using re as a discount factor
Summary
The essence of discounted cash flow valuation is simple; the asset is worth the expected cash flows it will generate, discounted to the reference date for the valuation exercise (normally, the day of the calculation). Penman & Sougiannis (1997) argued that GAAP (Generally Accepted Accounting Principles) earnings could be substituted for dividends in equity valuation, as long as analysts would reduce future earnings and book value to reflect dividend payments All these models were prone to double-counting (Penman & Sougiannis (1997) described that ―discounting earnings as if they were cash flows paid out to stockholders while counting the growth that is created by reinvesting those earnings will lead to the systematic overvaluation of stocks‖), something that was discussed in Glassman & Hassett (2000).
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