Common DCF Model Mistakes

Overview of Common Mistakes in DCF Models

How to “Sanity Check” a DCF Model

The DCF model states that the value of a company is equal to the sum of all of a company’s projected free cash flows (FCFs), which are discounted to the present date using an appropriate discount rate.

However, the discretionary assumptions used to project a company’s future performance are its main drawback, as these decisions are subjective and prone to the biases of the individual performing the analysis.

For that reason, the valuations derived from a DCF can vary greatly from each other.

The checklist below summarizes a few common errors often found in DCF models:

• Inclusion of Free Cash Flows (FCF) Before Year 1
• Too Short Initial Stage 1 Forecast Horizon
• Depreciation ≠ Capital Expenditures in Final Year of Forecast Period
• Mismatch in Free Cash Flows (FCFs) and Discount Rate
• Unrealistic Reinvestment Assumptions
• Forgetting to Discount Terminal Value (TV)
• Mismatch in Exit Multiple and Valuation Multiple
• Terminal Value > 75% of Implied Valuation
• Disregard of Relative Valuation — No “Sanity Check”

Inclusion of Free Cash Flows (FCF) Before Year 1

The first mistake seen in DCF models is accidentally including the latest historical period as part of the Stage 1 cash flows.

The initial forecast period should consist of only projected free cash flows (FCFs) and never any historical cash flows.

The DCF is based on projected cash flows, not historical cash flows. While most understand this concept, many DCF models are linked from a separate tab, where the historical periods will also be carried over and may be erroneously linked into the DCF calculation.

As a result, make sure to discount and add only the company’s future cash flows.

Too Short Initial Forecast Horizon (Stage 1)

The next error is related to having an initial forecast period that is too short, i.e. Stage 1.

For a mature company, a standard five-year forecast horizon is sufficient, i.e. the company is established with predictable cash flows and profit margins.

The time necessary for a mature company to reach a long-term sustainable state is brief — in fact, it could be even shorter than five years, if appropriate.

On the other hand, certain DCF models performed on high-growth companies need to extend the initial forecast period to a ten or even fifteen-year horizon.

Ask yourself, “Can this company continue to grow at this growth rate perpetually?”

If not, the forecast should be extended until the company matures further.

However, note that the longer the initial forecast period, the less credible the implied valuation is — which is also why the DCF is most reliable for mature companies with established market positions.

Depreciation ≠ Capital Expenditures in Final Year of Forecast Period

Closely related to the prior mistake, a company’s depreciation as a percentage of its capital expenditures (Capex) should converge near a ratio of 1.0x, or 100%, by the end of the initial forecast period.

As a company matures, the opportunities for capital expenditures decline, resulting in less capex overall. More specifically, the majority of the company’s capex will be maintenance capex, as opposed to growth capex.

Given the reduced capex, having depreciation outpacing capex perpetually would be unrealistic as depreciation cannot reduce the value of a fixed asset (PP&E) below zero.

Mismatch in Free Cash Flows (FCFs) and Discount Rate

The most common DCF model is the unlevered DCF, where the free cash flow to firm (FCFF) is projected.

Since FCFF represents the cash flows that belong to all stakeholders, such as debt lenders and equity holders, the weighted average cost of capital (WACC) is the appropriate discount rate to use.

In contrast, the levered DCF — which is used far less common in practice — projects the free cash flow to equity (FCFE) of a company, which belongs solely to common shareholders. In this case, the correct discount rate to use is the cost of equity.

Unrealistic Reinvestment Assumptions

Generating future growth requires spending, so it cannot just be reduced without reason.

Of course, reinvestments such as capex and the change in net working capital (NWC) will gradually decrease as a company matures and revenue growth slows down.

Yet, the reinvestment rate must still be reasonable and in line with that of the company’s industry peers.

For example, a company can be assumed to grow at 2.5% perpetually, but rational assumptions must be made where the continued revenue growth is supported, as opposed to simply cutting reinvestments to zero.

Forgetting to Discount Terminal Value (TV)

After calculating the terminal value (TV), a crucial next step is to discount the terminal value to the present date.

An easy mistake to make is to neglect this step and add the undiscounted terminal value to the discounted sum of the free cash flows (FCFs).

The terminal value is calculated using either:

• Perpetuity Growth Method (or)
• Exit Multiple Methods

But regardless of which approach is used, the terminal value calculated represents the present value (PV) of the company’s cash flows in the final year of the explicit forecast period prior to entering the long-term perpetuity stage, not the value as of the present date.

Since the DCF estimates what a company is worth as of today, it is necessary to discount the terminal value (i.e. the future value) to the present date, i.e. Year 0.

The following formula is used to discount the terminal value.

Present Value of Terminal Value Formula

• Present Value of Terminal Value = Unadjusted TV / (1 + Discount Rate) ^ Years

Unrealistic Terminal Growth Rate Assumption

The terminal growth rate assumption refers to the growth rate at which a company is expected to grow at into perpetuity.

One common error seen — particularly for high-growth companies — is an unrealistic terminal growth rate, such as 5%.

If a company is growing quickly far above its peers, extend the explicit forecast period until its growth rate normalizes.

A reasonable terminal growth rate assumption should generally be in line with the GDP growth rate, i.e. between 2% to 4%.

For a long-term growth rate in the upper part of that range (i.e. 4%), there should also be a valid reason supporting that assumption — e.g. a market leader such as Amazon (AMZN).

Otherwise, the terminal growth rate of most companies should be around 2% to 3%.

Mismatch in Exit Multiple and Valuation Multiple

In the exit multiple approach of calculating the terminal value, the exit multiple chosen should correspond to the cash flows projected.

For an unlevered DCF, the multiples used are typically EV/EBITDA or EV/EBIT.

Why? Enterprise value represents all stakeholders, just like unlevered free cash flows.

But in the case of a levered DCF, where levered free cash flows are projected, an equity value-based multiple must be used such as the price-to-earnings ratio (P/E).

Terminal Value > 75% of Implied Valuation

One of the most common criticisms of the DCF model is the contribution of the terminal value to the total implied valuation.

While a terminal value that is 60% to 75% of the total DCF value is ordinary, a terminal value that exceeds 85% of the total DCF value is a red flag that suggests that the initial forecast period should be extended and/or other assumptions likely require adjusting.

The perpetuity growth approach can also be used to cross-check the exit multiple approach’s terminal value (and vice versa).

The solution to this issue is to first prolong the explicit forecast period, as it might not be long enough for the company to have reached a normalized, stable growth state in the final year.

If that does not fix the problem, the terminal value assumptions such as the long-term growth rate could be too aggressive and not reflect stable growth.

Disregard of Relative Valuation — No “Sanity Check”

The DCF suffers from many drawbacks, with the most notable one being the overall sensitivity of the model to the assumptions used.

Hence, it is important to perform scenario analysis and sensitivity analysis to any complete DCF valuation model.

The independence of the DCF from the market is considered one of its benefits, but entirely neglecting the market price can often be a mistake.

Intentionally not performing any comps analysis as a “sanity check” under the reasoning that the market is the wrong approach.

The DCF and comps analysis should be used together, which is why institutional investors and investment banks never rely solely on one valuation method — albeit, there are times when certain approaches are weighted more heavily than others, such as if there are no comps.

Therefore, the intrinsic value and market value approaches should be used in conjunction to determine a valuation range, rather than attempting to pinpoint a single, precise valuation.

Learn More → Common Errors in DCF Models (Michael J. Mauboussin)