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

QUESTION AND ANSWER SESSION

Question: Does the formula work if the ROE declines with a higher book value?

Lee: Yes, the math works. But the key question is whether you can forecast ROE well. The task is more difficult for growth companies because the bulk of their free cash flow is generated further in the future.

Question: How long does the specific forecast period have to be to get the best result from the valuation model?

Lee: I can tell you what we do, but that doesn’t mean our way is in any way optimal. I aim for a period of explicit forecasts that is long enough that I will not have to add another growth rate to the terminal value. Typically, a fixed period of about 10 years will do the job. If the explicit forecast period is long enough, I can simply assume a growth rate equal to the nominal GDP rate for the terminal value.

Question: Regarding the terminal-value problem, what is the discount rate used in calculating the PV of the cash flow during the explicit period and the PV of the cash flow beyond the explicit forecast period?

Lee: We use the same discount rate for both cash flow periods. We sometimes make an adjustment to growth for the cash flows in the terminal-value period that isn’t made for cash flows in the explicit forecast period, so it may appear to be a different discount rate, but it is still r − g.

Question: The RIM requires the clean-surplus relation, which requires estimated dividends, so why not use the DDM? In other words, what is the advantage of the ...