Like woodworking tools in the hands of a skilled craftsman, the income and market approaches to business valuation are the tools of the trade for the valuation analyst. Similarly, the results that are achieved depend greatly on the manner in which those tools are applied.The focus of this article will be on making the most of the toolbox, particularly with respect to three common threads in both the discounted cash flow method and the guideline public company method: cash flow, growth and the weighted average cost of capital.
INCOME APPROACH - DCF
When it comes to the income approach, perhaps the most common method is the discounted cash flow, which for general business valuation purposes is most often presented in a debt-free, or unleveraged, framework and correspondingly relies on weighted average cost of capital as the discount rate.
While very useful, the DCF is extremely sensitive to the assumptions of the subject company's operating forecast. Accordingly, when discussing future growth and operating performance with management, it is particularly appropriate to request that the forecast be discussed in terms of an "expected value" outcome. This does not mean the most probable or the best-case outcome but, rather, a weighted average of all possible future outcomes.
This intuitive procedure, although seemingly unwieldy, permits consideration of multiple growth scenarios, along with their respective risk (probabilities), with which to determine the one outcome that ultimately defines the DCF. Thus, this process provides a better benchmark of the hypothetical market participant's viewpoint, due to the inclusion of multiple risk-adjusted (probability-weighted) scenarios that would be viewed as relevant as of the valuation date.
If expected value outcomes can't, or won't, be discretely captured in the forecast at the line-item level, an expected-value case can still be obtained by applying a well-documented process called certainty equivalence to the cash flows that stem from the original forecast. This involves the application of cumulative discounts to the forecasted cash flows such that an expected-value cash-flow forecast is obtained.
While certainty equivalence might merit consideration in any DCF-related application, the method is particularly useful in purchase-price allocation work, where the purchase price is already known, the hypothetical market participant's view of the WACC for the target can be readily estimated, and the only true "variable" pertains to whether the stated projections are reasonably reflective of the parties' common viewpoint in general and a hypothetical market participant's viewpoint in particular. The rate of growth and the magnitude of cash flows can be readily adjusted through certainty equivalence such that the ultimate DCF conclusion matches the purchase price exactly at a reasonable WACC.
Whether expected-value outcomes, certainty equivalence or some other method is ultimately employed, the obvious point is that an analyst has readily available options to assess firm-specific risk in the cash flows, rather than in WACC. There certainly is not universal agreement on this point, however, and perhaps the most contentious issue among practitioners is how much (if any) firm-specific risk should be addressed in WACC.
This contention notwithstanding, the analytical preference for firm-specific risk assessment in cash flows, versus WACC, is well-documented in academic literature.
MARKET APPROACH - GPCM
Under the market approach, there is perhaps no more contentious issue between clients and valuation practitioners than the selection of comparables under the guideline public company method.
Most of the debate stems from a premise that I refer to as "functional similarity." Clients routinely bristle at the typical group of comparables put forth as being similar to their company because, inevitably, there is some degree of functional dissimilarity between the group and the subject company. This reliance on functional similarity sometimes causes many comparables to be eliminated under the GPCM or, in extreme cases, for the market approach to be abandoned altogether.
How important is functional similarity in practice? One way to answer this question is to review the fundamental characteristics of a multiple. According to the Gordon Growth Model, the well-documented and generally accepted method of determining a terminal multiple of cash flow under a DCF, a reasonable multiple of operating cash flow can be expressed as:
1 / (k-g)
where k = WACC and g = growth.
For example, if k = .125 and g = .025, the multiple is 10.0x. Thus, the GGM implies that the most critical factors driving enterprise value multiples might reasonably be stated as the required rate of return on invested capital and the growth rate. Based on this, one way to employ these fundamental drivers would be to select comparables with WACC similar to that of the subject company, and then analyze how growth, either trailing or forward, is correlated with the observed EV multiples within the data set.
Traditionally, the attempt to find comparables with similar WACC has implicitly fallen to the premise of functional similarity, where choosing comparables within the same general industry has (largely inadvertently) resulted in generally similar WACC. However, it should be noted that functional similarity is not a requirement, per se, of locating comparables with similar WACC.
In fact, one can quite readily search any properly equipped financial database and locate numerous comparables with very similar WACC, not necessarily due to functional similarity but to similar historical systematic risk exposure. In fact, under a GPCM, data on both WACC and g for comparables is widely available.
Thus, although it may not be necessary to choose functionally dissimilar comparables to pursue similar WACC, analysts can bolster the conclusions of a GPCM by reasonably isolating companies with generally similar WACC, evaluating the observed multiples' correlation with a specified g metric, and then assessing a reasonable multiple based on the specified g metric for the subject.
POWER TOOLS
The DCF and GPCM are arguably the most powerful tools of the valuation practitioner. Both methods are greatly impacted, whether explicitly or implicitly, by growth, cash flow and WACC. The reliability of both methods is strengthened when there is strong analytical and academic support for not only the manner in which the tools are applied, but also the manner in which the three common threads are evaluated and factored into the analyses.
Jim Kelley is a CFA and a senior manager with CBiz Valuation Group LLC.
