Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

ESTIMATION ISSUES

The real challenges in valuation are questions of estimation, not problems with the existing model. Investors need to revisit the fundamental aspects of the estimates required for DCF analysis. In the process, they may develop a better framework for looking at valuation.

Nominal versus Real Valuation

One of the first decisions in DCF analysis, especially for valuations of companies outside the United States, is the basic decision of whether to do valuations in nominal or in real terms. In theory, using nominal cash flows and nominal discount rates will produce the same value, but when inflation rises above 10 percent, DCF valuations start falling apart in nominal terms because they become extraordinarily sensitive to small changes in assumptions. The solution is to use real valuation or perform the valuation in a different currency.

In real valuations, we look at cash flows prior to considering inflation, and we discount them at real discount rates, which are also before inflation. Discounting real cash flows at the real discount rate yields the value of the company. The two biggest problems with this approach are that taxes are still computed based on nominal, not real, income and that estimating real risk-free rates and risk premiums is far more difficult.

An alternative is to do the valuation in a more stable currency. In Brazil, for example, DCF valuation is typically done in U.S. dollar terms. Analysts might think that using this approach means they do not ...