Discounted cash flow: common methodological errors

Investor Foundations introduced the construction of a basic discounted cash flow model. This lesson addresses the methodological errors most frequently observed in practice.

The discount rate

The capital asset pricing model (CAPM) is the standard theoretical basis for the cost of equity. In practice, beta estimates are unstable, the equity risk premium is subject to considerable disagreement, and small changes in inputs produce large changes in value. Most practitioners therefore use CAPM as a reference point and apply judgement.

A practical approach is to begin with the long-term risk-free rate, add an equity risk premium of 4.5% to 5.5%, adjust for business-specific risk, and state the resulting rate and its derivation explicitly. A 9% discount rate with a stated rationale is preferable to an 8.7% rate derived from a beta estimated over an arbitrarily selected period.

The discount rate should not be adjusted for risks that can be modelled directly in the cash flows. A 30% probability of losing a major contract should be reflected in the cash flow forecast or in a scenario, not by increasing the discount rate by two percentage points. Adjusting both double-counts the risk and obscures the assumption.

Terminal value

The terminal value typically constitutes 60% to 80% of enterprise value and is frequently the least scrutinised component of the model.

The perpetual growth rate must not exceed the long-run nominal growth rate of the economy; a higher rate implies that the company will eventually exceed the size of the economy.

The terminal value should be tested in two respects. First, the analyst should calculate the exit multiple implied by the perpetuity assumption and assess whether it is plausible for a mature business in the industry. Second, the analyst should determine the return on incremental capital implied. Perpetual growth requires perpetual reinvestment at a return above the cost of capital, which presupposes a permanent competitive advantage.

Reinvestment

The error that most commonly inflates valuations is forecasting revenue growth without the reinvestment required to achieve it.

In a correctly specified model, the reinvestment rate is not an independent assumption. It is determined by the growth rate and the return on incremental invested capital (RONIC):

Reinvestment rate = g / RONIC

At growth of 6% and RONIC of 15%, reinvestment must equal 40% of NOPAT. Free cash flow is the remainder. A model that grows revenue at 10% while holding capital expenditure constant at 3% of revenue produces free cash flow that cannot be realised.

Scenario analysis

A sensitivity table varies one input at a time, whereas in practice assumptions move together. In a downturn, revenue declines, margins contract, working capital increases and capital expenditure is reduced simultaneously.

The analyst should construct three internally consistent scenarios in which assumptions move together, and assign approximate probabilities to each. The probability-weighted value is more informative than the base case alone, and the downside scenario provides the basis for position sizing.