Equity Valuation: Models from Leading Investment Banks

23

A Quick Guide to DCF and Economic Profit Analysis

Here, we review the precepts of DCF and economic profit analysis and explore some issues to consider when using discounted cash flow/economic profit analysis (DCF/EPA)-based valuation models such as VCAM.

23.1 POWERFUL ANALYTICAL FRAMEWORKS, BUT NOT A COMPLETE SOLUTION

Discounted cash flow/economic profit analysis (DCF/EPA) is a DCF model with accompanying ROIC and economic profit calculations for each forecast year.¹ DCF/EPA analysis provides an effective framework for evaluating whether economic value will be enhanced under certain assumptions.

Forecasting the future to estimate current share values is really an exercise in estimating the probability of a variety of possible outcomes rather than a specific estimate. Investors must look into the near and distant future and make assumptions regarding how the economics and fundamentals of an industry/business will affect all elements of the DCF/EPA framework on a probability weighted forecast scenario basis.

We believe DCF/EPA models are very useful analytical tools. In particular, these models can:

• (1) Identify valuation discrepancies between conventional valuation methodologies;
• (2) Gauge the effectiveness of capital utilization;
• (3) Reveal and quantify the differing means of creating value for various industries/companies;
• (4) Help signal market expectations; and
• (5) Provide effective frameworks for various scenario and share value sensitivity analysis.

23.2 DYNAMICS OF ECONOMIC ...