What are “DCF Sense Checks”?
DCF valuation relies on the valuer’s own cash flow forecasts, which are in turn dependent on many assumptions. This reliance on assumptions is both a strength and a weakness of this method; a strength because these assumptions require an analyst to think in detail about the company’s business drivers and future performance but a weakness because the final valuation is often highly sensitive to the assumptions. It is important to remember that the reliability of the DCF valuation is dependent on the quality of the assumptions.
Analysts must undertake sense checks to test the reasonableness of the output generated using DCF valuation.
Sense checks can be done by:
- Trend analysis over time: Are the values within the expected range?
- Peer comparison: Are the results consistent with peer company metrics?
- Analysis of interrelated metrics: Do related values move as expected relatively?
Key Learning Points
- DCF relies on the valuer’s inputs and assumptions. The reliability of the valuation is dependent on the quality of the assumptions.
- The reliance on many assumptions in DCF analysis is both a strength and a weakness of this method
- DCF valuation is very dependent on key assumptions with even small changes producing large value variations
- Sense checks help in checking the reasonableness of these assumptions and the resulting output
The Need for DCF Sense Checks
A DCF analysis calculates the enterprise value of a business as the present value of its forecasted free cash flows. A strength of DCF analysis is the requirement to think about and forecast key business drivers. This leads to a fuller understanding of the business fundamentals. It also serves as an important counterpoint to market-based valuation techniques, which may sometimes be vulnerable to market distortions.
However, DCF valuation is very dependent on key assumptions with even small changes producing large value variations. Sense checks help in checking the reasonableness of these assumptions and the resulting output.
DCF Sense Checks Explained
To recap from our earlier blog on DCF analysis, here are the steps involved in undertaking a DCF analysis:
- Forecast free cash flows to steady state (normally 5 or 10 years)
- Calculate Weighted Average Cost of Capital (WACC)
- Calculate terminal value
- Discount cash flows to today
- Calculate implied share price from enterprise value using the bridge
We look at the sense checks undertaken at the various stages of DCF valuation.
Sense Checks on Key Ratios
The forecast free cash flows are made up of many assumptions concerning business drivers and future performance. These assumptions go beyond the forecast period and are also applicable during the steady state period. It is helpful to construct key business ratios to check for the reasonableness of these assumptions. These ratios should be sector specific but are likely to include:
Ratio | Sense check |
Sales growth over the forecast period and in the steady state | – Benchmark against comparables
– Should be modest by steady state |
EBIT margin | – Benchmark against comparables
– Should be modest by steady state |
Capex as a % of sales | – Benchmark against comparables and be logical given sales growth rates
– Should be modest in steady state |
Operating Working Capital as a % of sales | – Benchmark with comparables
– Should be steady by the terminal period |
Return on Invested Capital ( ) | – Should be just above once in steady state |
Replenishment ratio (Capex/depreciation) | – When in steady state, should be just over 1 (assuming inflation) |
Cash conversion rate | – Should be higher in steady state as investment requirement reduces |
Reinvestment rate | – Should be lower in steady state |
Sense Checks on Terminal Value
Since the terminal value is normally a large proportion of the overall value, it is critical that the reasonableness of the forecast is sense checked. In addition to sense checking the ratios above in the steady state, the following calculations provide a sense check on the terminal value:
The implied multiple in the growing terminal value | Benchmarked with comparable multiples |
The implied growth rate in the | Compared to the long-term nominal GDP growth rate |
Sense Checks on the Output
As part of DCF analysis, the following calculations should always be undertaken and benchmarked:
Implied share price as a % of the traded share price | – If dramatically different, then the assumptions made by the market are different to those used in the DCF
– The possible reasons to explain why should be explored |
EV EBIT or EBITDA multiples implied by the DCF | – Benchmark against comparables |
% of value from terminal value | – Typically, in the 60% to 90% range, although this depends on the duration of the forecast period |