The importance of probability in Discounted Cash Flow (DCF) valuations

There are various ways in which you can value a business or growth project, with popular business valuation methodologies including earnings multiples, asset-based approaches, entry costs or discounted cash flow methodologies. 

A discounted cash flow methodology in particular provides an interesting valuation tool, given that this method can be applied to growth projects, alongside typical business valuation scenarios. However, this methodology requires relatively detailed assumptions regarding future operations of the business which is not always achievable or practical in owner managed scenarios.

Therefore, in this article we discuss how taking a probability weighted approach in situations where a discounted cash flow methodology must be used, can provide a more accurate picture of value and avoid layering assumptions – resulting in a more realistic and commercially viable approach.

What is a Discounted Cash Flow Model? 

Discounted cash flow (DCF) is an income-based approach to valuation (as opposed to asset-based or market-based approaches), and is a comparatively technical method which draws heavily on long-term assumptions and predictions about business conditions. 

The approach is based on the theory that the value of a business is equal to the current value of its projected future benefits, which includes the present value of its ‘terminal’ worth. That terminal value doesn’t assume the end of the business, but represents a point in time when the projected cash flows level off or flatten. 

The projected cash flow, totaled together with the terminal value, are then appropriately discounted to reflect the risks of investing in the specific company being valued. Taken together to arrive at an estimate of current value. In investment scenarios, that estimate can then be used to consider investment potential; if the value arrived at is greater than the current cost of the investment, the investment opportunity is regarded as a positive one. 

The calculations undertaken to determine a DCF valuation of a business are complex and require specialist knowledge in order to be applied appropriately. Our valuation e-book sets out examples that explain the process and key assumptions in more depth. 

When is a discounted cash flow model used? 

A discounted cash flow is primarily used for two key purposes, being: 

1. Company valuations; and 
2. Capital budgeting decisions or project analysis. 

A company valuation may be needed for a number of specific share processes – such as gifting or selling shares, on the death of a shareholder, or to help determine a share price as part of an equity raising share issue – as well as acquisition or for business planning purposes.  

Capital budgeting is the process of identifying and evaluating projects which will generate cash flow to the company in the future. This can include capital investment in machinery (which may be a replacement for normal business operations or an expansion to increase capacity), new product launches and compliance related projects, amongst others. 

Limitations of DCF methodology 

As with any valuation methodology, a DCF valuation is highly sensitive to the assumptions on which they are based. This in turn has a significant impact on decisions made my management, be it in relation to a sale or whether a project goes ahead (which in turn has repercussions for future profitability and business valuations). It is therefore essential that assumptions and estimates are based on reality and tailored in the most appropriate way possible. 

Four key common limitations of a traditional discounted cash flow model are: 

1. Cost of Capital Assumption – The calculated cost of raising funds for a company/project is taken as a weighted measure of the cost of debt financing (such as interest on a loan/overdraft) and the cost of raising equity (implicit returns required by equity investors). However, simply using this weighted average Cost of Capital (often referred to as WACC) as a discount rate without adjusting it for the risk present to the company or the proposed project may lead to significant errors when assessing the value proposition.
2. Management Reactions and Decisions/’Optionality’– In reality, future cash flows and decisions are not fixed/determined at the present day and in owner managed businesses are often not easy to reliably predict. Instead, future cash flows are dependent on a series of management decisions throughout the lifecycle of a business or project, which take into account recent performance and trends. 
3. Terminal Value – It is difficult for any business owner to reliably estimate cash flows in the near future, and even more challenging to estimate cash flows which stretch even further into the unknown. Therefore, a business valuation can be significantly affected by assumptions made about the terminal value in the DCF, which are typically subjective and quite often wrong.  
4. Forecast financial performance – as mentioned above, accessing accurate forecast financial performance can be inherently challenging for owner-managed businesses. Forecasting performance is subjective by nature and may not be based upon realistic or considered assumptions. There is also the risk that, depending on the purpose that they were prepared for, expected performance is predicted on an overly cautious or overly ambitious basis.  

A solution to the limitations – a probability weighted discounted cash flow model 

Under a probability weighted discounted cash flow model, a number of scenarios are considered (typically base, worst and best case, incorporating factors such as inflation, growth or decline rates and customer concentration risk, among others) with probabilities assigned to each. Management options are then assessed and incorporated into the model and the discounted cash flow is calculated. This provides a more realistic intrinsic value calculation which helps to deal with some of the issues surrounding a normal discounted cash flow model.  

As discussed above, the cost of capital assumption is an important estimate in determining the value of a company or project. Too high and the future cash flows are discounted too heavily and results in a low (or negative) project value. Too low and the future cash flows are not discounted appropriately and results in an artificially high valuation. While the impact of different scenarios occurring can be understood by making adjustments to the discount rate applied, it is far easier to make informed judgements on the probability of success and adjusting accordingly.  Understanding the detail of the various possible scenarios and weighting these on a probability basis allows us to take into account the risks and different pathways without applying arbitrary assumptions to the whole calculation.

In reality, managers are provided with decisions further down the line which can change future cash flows, called ‘real options’. These real options give managers the right (but not obligation) to make decisions about projects, be it: 

1. Timing options – delaying projects until more information is obtained or more clarity is gained around demand; 
2. Expansion options – following a successful project launch, additional investment may be made to increase production; 
3. Abandonment options – alternatively, if projects are expected to be loss making these can be abandoned, with any costs incurred to date considered to be sunk costs; or  
4. Flexibility options – managers may increase or decrease price or production in line with demand, among other factors. 

This degree of ‘optionality’ is not factored into a traditional discounted cash flow model, despite its clear practical real-life applications. In a probability weighted discounted cash flow models, however, these considerations are factored into the probability weighted pathways.  

Finally, terminal value is typically determined by either a Gordon Growth model, or (more commonly in the owner-manager world) a multiple of earnings approach. The multiple used is typically ‘bearish’, representing the uncertainty of future earnings and reflecting the likelihood that current valuation multiples might not persist over the long-term. If possible, using a cyclically adjusted average is better (i.e., the average take from across one economic cycle). However, a probability weighted DCF can take this one step further, applying the probability to the terminal value and reducing the reliance on just one or two assumptions for the final valuation.  

One particularly interesting application of a probability weighted method is applying different probabilities to costs and revenue, reflecting contracts and knowledge about future prices, but not sales. However, be wary! Overcomplicating a probability weighted DCF essentially leads to a Monte Carlo simulation – a mathematical technique which weights thousands of simulations to create a probability distribution of outcomes. Whilst these can be useful tools for valuations where multiple scenarios exist (i.e., growth shares), it’s always good to start here rather than accidentally end up with one! 

A practitioner’s view 

It is important to note that the DCF valuation methodology is not a new concept and has actually been around for hundreds of years, although it was ‘popularised’ in the 1930s by John Burr where it was applied specifically to businesses and industries with stable cash flows, such as the coal industry.  

In reality, most owner-managed businesses are not easily comparable to the coal industry and often do not benefit from stable cash flows, therefore when conducting a valuation, we will always try to consider alternative valuation methodologies to DCF initially. If we have to use a DCF, we are more frequently applying a probability weighted DCF to our valuation methodology, particularly for early-stage businesses where there is high expected volatility and lots of ‘hope value’ exists.  

This makes sense, given that within a business there are a number of potential scenarios that could play out, and valuing on the basis of only one potential pathway leaves room for a lot of error and potentially missed value. Therefore, utilisation of this technique provides a more sensible and realistic view of the future, opening up the opportunity to discuss true value whilst also providing investors or shareholders with the confidence to know that the key risks have been understood and incorporated.