Sunday, 6 October 2013

DCF (I): a great negotiation and M&A tool; a great valuation lie

A detailed Discounted Cash Flow (DCF) model is all we need to assess the value of a company, isn't it?

Let's start with a few simple questions:

1. How many variables do we normally have to estimate in a typical detailed DCF model? Sales, COGS, SG&A, R&D, D&A, capex, change in working capital, tax rate, growth rates, interest rates......and all this for several years into the future. Let's be optimistic and say that only 10 variables need to be estimated.

2. For each of these variables, what's the probability that we estimate them accurately (less than 10% estimation error)? Let's say that we are the world's greatest economic & business forecasting geniuses ever and that the probability is 80%.

3. Given (1) and (2), what's the probability that we end up with the right estimate for the value of the company (less than 10% estimation error)? The answer is: 10.7%.

If we actually have to estimate 20 variables instead of 10, the probability drops to some fabulous 1.2%. And if we do just have to estimate 10 variables but our forecasting accuracy instead of 80% is just 65% for each of them (we would still be the best economic & business forecasters ever) the probability that we end up with an accurate result for the value of the company is a spectacular 1.3%.

Meaning: a detailed DCF is an excellent tool to simulate the impact on valuation of different and very detailed economic & business scenarios. However, given the intrinsic difficulty in forecasting the future any detailed economic & business scenario taken as the basis for a company valuation is doomed to be proven wrong. And, alas, so is the derived company valuation.

Nevertheless, and funny enough, a detailed DCF is an excellent negotiation and M&A tool. After all, what is a successful M&A deal but a negotiation process at the end of which a company is taken over by another one? And what is a successful negotiation process but a mutual agreement on a future economic & business scenario and the resulting valuation for the company to be acquired? By allowing to simulate such a detailed scenario and derive the corresponding company valuation, a detailed DCF model allows buyer and seller to agree on a transaction value in an apparently scientific way - which provides much comfort to both parties.

The only problem is that this comfort is based on both the planning fallacy and the supreme illusion of control: "the more detailed we plan and forecast, the better are we prepared to deal with the future". Big mistake.

The future is inherently uncertain, with the degree of uncertainty increasing more than proportionally with the increase in the planning / forecasting horizon. This means that the higher the degree of detail with which we try to forecast the future, the higher will be the probability that we will be proven wrong.

Now let's combine a potential buyer's tendency to be optimistic about the economic & business environment for the business he is targeting in an M&A deal (why would he otherwise be willing to acquire it?) - and the seller's ambition to maximize the proceeds of his disposal - with a detailed DCF model. What do we end up with? A very detailed future economic & business scenario, on which both negotiation parties agree, that is biased to the upside. The buyer overpays. And this explains why 2/3 to 3/4 of M&A deals end up being value destructive for the acquirer.

Cutting a long story short: a detailed DCF model may be a great negotiation (and marketing) tool. But it is a philosophical and mathematical mistake.

If using a detailed DCF model to value a business is nonsense, what's an investor's alternative to perform a sensible valuation? A few cues: keep the focus on the big picture. Quantify it. Quantify it. Quantify it. Keep it simple. Look for inconsistencies.  Remember that it is better to be roughly right than precisely wrong. Think twice before paying for growth. Allow for a margin of safety. Understand that less is more.

More about this in my next post.

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