How to Sanity Check Your DCF Analysis and Avoid the Top 3 Errors

Learn how to check your DCF analysis for the three most common errors in this lesson, including problems with the Terminal Value, the PV of the Terminal Value, and the double-counting of items. You will also see a demonstration of how you might fix a DCF and make the analysis more meaningful. http://breakingintowallstreet.com/ "Financial Modeling Training And Career Resources For Aspiring Investment Bankers"

Table of Contents:

1:50 The 3 Mistakes to Avoid in a DCF

7:07 How to Fix the Top Mistakes in a DCF

9:01 How to Fix Our DCF in Excel

15:41 Recap and Summary

Lesson Outline:

Common question: “I need your help. I didn’t get a chance to go over the entire course yet. I am working on a DCF (Discounted Cash Flow) model and need to make sure my model is error-free.”
“Are there any sanity checks I can do? Or any simple ways of making sure my model isn’t wrong?”

This is a difficult question to answer because there isn’t necessarily a “correct” answer to a financial model, or a “correct” way to build one.

However, there are definitely some common mistakes, especially in a standard analysis such as the DCF.

The Top Three Most Common Mistakes in a DCF

Problem #1: How much of the company’s Present Value comes from the PV of its Terminal Value?

If it’s 80-90%, you have a problem.

Ideally, it should be 50-60% or less, depending on the industry and the company’s maturity.

It’s not the end of the world if it’s 65%, but if it’s in the 80-90%+ range, there’s little point in even running a DCF analysis since so much of the value comes from the Terminal Value at the end.

Problem #2: Do the Implied Long-Term Growth Rate and the Implied Terminal Multiple make sense?

These should be in-line with the GDP growth rate or growth rate of the overall economy and the multiples of the public comps, respectively.

So if the long-term growth rate is 10% but the GDP growth rate is 3%, you’re in trouble, and you’re also in trouble if the implied multiple is 10x but the comps trade at 8x.

You generally want the implied long-term growth rate to come in below the GDP growth rate, and you generally want the implied multiple to be at or below the median multiple from the comparable companies, since multiples tend to decline over time as companies become more mature.

Problem #3: Are you double-counting items?

The rule is very simple:

If an item is included in FCF, leave out of the Implied Enterprise Value to Equity Value calculations at the end.

If an item is not included in FCF, keep it in the Implied Enterprise Value to Equity Value calculations at the end.

For example, with Interest Expense, if you leave it out (as in Unlevered FCF), you DO want to subtract debt at the end when moving from Enterprise Value to Equity Value.

On the other hand, if you leave it in, you’re calculating Levered FCF and you do NOT want to subtract debt at the end because you’re just calculating Equity Value, not Enterprise Value.

How to Fix These DCF Mistakes

Fix #1: Extend the projection period to 10-15 years instead, since 5 years is often too short.

Extending the projection period will often fix other problems as well, such as the long-term FCF growth rate being significantly different from FCF growth in the final year.

Some people will argue that 10-15 years is too long, but the truth is, management teams and executives make decisions based on long-term planning. No one will decide on a major initiative based on a desire to improve results over only a few years.

Fix #2: Reduce the Terminal Value by using a lower long-term growth rate or a lower terminal multiple.

If you use a multiple or a growth rate more in-line with the ranges recommended above, you’ll be more likely to get meaningful results in the analysis.

The company should never be growing faster than the economy as a whole into perpetuity.

Fix #3: Increase the Discount Rate, since it will impact the Terminal Value more in most cases and reduce the contribution from the PV of the Terminal Value.

While this fix can sometimes work as well, it is generally not a great idea because the Discount Rate DOES still impact the Present Value of Free Cash Flow as well.

So you may need a dramatically different Discount Rate to reduce the contribution from the Present Value of the company’s Terminal Value.

RESOURCES:

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