Firm valuation is a complicated exercise that determines the value of a company or its assets for a variety of reasons:
– To set a baseline price to negotiate a fair sale or merger
– As the start-up of an expansion strategy
– To assess the value of shareholders’ equity for reporting purposes
– For leveraging purposes, as the company needs to apply for credit
– To establish asset value in an eventual owners’ dissolution
The list can go on and on. However, this method is not only based on the type of business, market, or sector influenced by the firm. In most cases, the purpose of the valuation determines the method applied.
There is an interesting approach to “adjusting” the Discounted Cash Flow (DCF) formula, proposed by Professor Richard Ruback of Corporate Finance at Harvard Business School on the cited paper. The proposal of Professor Ruback is an implementation for inaccurate forecasts product of a missing component. The argument consists of the fact that cash flow forecasts are setup by prolonging income statements into the future, based on historical patterns used as a baseline. Predicting earnings into the future commonly uses a unique picture of circumstances. This single scenario consists of a rather rigid benchmark that may not reflect the reality of the production or fluctuation of value in a given number of years. The lack of real outlines is why this hypothesis considers alternative forecasts, e.g., Best scenario, worst scenario, and base-case scenarios.
Revised DCFs attempt to avoid biased forecasts by incorporating deviations of the forecasted cash flow in a defined way: Expected Cash Flow = Forecasted Cash Flow + Missing Component. This “missing component” varies between 35% to 80% discount rates. In other words, the idea is to add a new factor to the DCF formula that pulls the result towards a more accurate figure. This factor or missing component can be solely the lower (pessimistic) forecast or depending on the local economy where the valuation takes place. One example could be a Country Risk Premium (CRP), which refers to the additional yield or benefit claimed by investors in order to compensate for the additional risk of investing in a foreign market, as opposed to investing in their domestic economy. An adjustment like the CRP would adjust an overrated forecast that overlooks scenarios of disadvantage. (Ruback, 2010).
By Orlando Gómez.
References:
Ruback, R. (2010) ‘Valuation when Cash Flow Forecasts are Biased’ Harvard Business School
[online]
Available at http://www.hbs.edu/faculty/Publication%20Files/11-036_079ea572-b3ca-43da-a626-233666307d15.pdf