Dcf Errors

In: Other Topics

Submitted By mayankanand
Words 5194
Pages 21
sCAPITAL MANAGEMENT

LEGG MASON

March 16, 2006

Michael J. Mauboussin

Common Errors in DCF Models
Do You Use Economically Sound and Transparent Models?
Discounted cash flow analysis is the most accurate and flexible method for valuing projects, divisions, and companies. Any analysis, however, is only as accurate as the forecasts it relies on. Errors in estimating the key ingredients of corporate value . . . can lead to mistakes in valuation. Tim Koller, Marc Goedhart, and David Wessels Valuation: Measuring and Managing the Value of Companies 1

A Return to First Principles mmauboussin@lmfunds.com Say you had to come up with a fair offer to buy your local dry cleaner and the seller limited the extent of your financial information to the answers to five questions. Which questions would you ask? Chances are you wouldn’t ask how the quarter is progressing or about last year’s earnings, but you would focus on the prospects for cash coming in versus cash going out over time. Sole proprietors understand intimately that the value of their business hinges on the cash flow the business generates. No distributable cash, no value. Cash puts food on the table and pays the mortgage; earnings do not. Equity investors are business buyers. While most shareholders own only a small fraction of a company, they are owners nonetheless. The source of shareholder value, and value changes, is no different than the sole proprietor’s: it’s all about the cash. Most investors don’t think this way. In part, this is because market exchanges readily allow investors to trade cash today for claims on future cash flows, and vice versa, encouraging them to forget they are evaluating, buying, and selling businesses. Yet investors, as opposed to speculators, should never lose sight of their objective: buying a stream of cash flows for less than what it is worth. Given that cash inflows…...

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