The discounted cash flow (DCF) method is a widely adopted methodology for the valuation of public and private companies in Canada. The following blog article explores how this methodology, as well as other valuation methodologies, are applied in practice and whether certain methodologies are more appropriate than others for differing valuation purposes. In particular, we explore why certain methodologies, and not the DCF, appear to be more common in the areas of tax valuations, matrimonial and commercial litigation, and whether this promotes more accurate and reliable business valuations.
The DCF was born from finance theory. Following the stock market crash of 1929, DCF analysis gained popularity as a valuation method for stocks. Irving Fisher in his 1930 book The Theory of Interest and John Burr Williams’s 1938 text The Theory of Investment Value first formally expressed the DCF method in modern economic terms.
The DCF has been widely adopted by corporate financial professionals, venture capitalists, private equity, angel investors, real estate investors, investment banking firms, and corporate acquirers. These finance professionals prefer to use the DCF (or derivatives thereof) for the valuation of private companies for investment, financings, acquisitions and IPOs.
Although there are critics of the DCF, this methodology appears to be widely used for some of the following reasons:
Given all of the above advantages, why do we see the prevalence of other valuation approaches, particularly in the areas of tax valuations (e.g., share restructuring, estate freezes, rollovers, etc.), and matrimonial and commercial litigation? We explore this further in the following section.
Some of the more commonly used valuation methodologies we encounter today include the following:
[Note to reader: Have purposely excluded Asset Approaches and Rules of Thumb from this blog article as they only apply in very specific situations, which are outside the scope of this article]
The Capitalized Earnings (CE) or Capitalized Cash Flow (CCF) methods are derivations from the Dividend Discount Model (DDM), which determines the valuation of a company based on one identical earnings or cash flow level, often growing at a constant growth rate into perpetuity.
In other words, the CE/CCF methodologies assume that the company’s earnings or cash flow will be the same each year forever, without any significant expansion or contraction over time. This methodology does not allow for fluctuating growth (or high growth periods) in revenue, nor fluctuating profitability levels over time. In addition, the CE/CCF assumes that working capital and capital expenditures are constant into perpetuity, which is rarely the case in practice.
However, the CE/CCF methodologies are very widely used in tax valuations, matrimonial and commercial litigation. We believe that some of the reasons for this are as follows:
The Market Approach methodologies relies on market multiples to value a private company. These methodologies are often used when a private company is at an early stage and not generating positive earnings or cash flow (or cannot foresee when positive earnings/cash flow will be achieved). However, we have also encountered these methodologies used for more established, cash flow generating businesses, given its ease of use and some industry practitioners preferring these methods.
Similarly to the CE/CCF methodologies described above, valuations under the Market Approach apply a “snapshot” on current value (e.g., multiple on last twelve months revenue or EBITDA), rather than a forward-looking perspective on earnings or cash flow. In addition, public company multiples can fluctuate due to factors unrelated to the subject company, and M&A multiples represent market negotiated pricing that may or may not have similar characteristics to the subject company being valued.
Although our preference is to use the DCF for most valuation situations, we do acknowledge that the other approaches have merit in specific situations:
In most other situations, we believe that the DCF provides more reliable and accurate business valuations in a notional context as it aligns best with what investors and finance professionals have adopted in Canada and around the globe. However, you should discuss the pros and cons of these valuation methodologies with your business valuator to better understand the rationale for its use.