Flaws in Discounted Cash Flow Valuation Methodologies - Coursework Example

Flaws in Discounted Cash Flow Valuation Methodologies Customer Inserts His/Her Name Customer Inserts Grade Course Customer Inserts Tutor’s Name 28, 08, 2011 Introduction Discounted cash flow valuation system involves the use of expected future cash inflows into a firm or an asset discounted the firms cost of capital or assets required rate of return in order to establish the present value of that asset. It is quite challenging establishing the future cash inflows and expected related outflows and liabilities due to uncertainty and generally lack of foreseeability of the future events. In this regards the very basis of discounted cash flow valuation is not the problem but getting the relevant inputs in order to get the relevant results. Discounted cash flow valuation model has been further been improved but incorporating uncertainty variables and sensitivity variables as being indicated in this report so as to address the limitation of uncertainty. This literature review will therefore further discuss the relevance to proper valuation of a firm or an asset with more reference to the various flaws inherent in the approach and their proposed solutions. The theory of firm’s value has gained more academic and professional recognition since it translates indirectly into tax liabilities, cost of investments, and damages in litigations and also the investment prices in the stocks market. It is therefore imperative that this papers elaborates on the literature that highlights on the red lights of the most commonly used valuation system so that relevant measures are taken in order to ovoid wrong decisions based on reliance on the information from erroneous valuation of assets and firms (Liu, Thomas &Nissim, 2007). Valuation of a firm therefore should always produce objective and transparent results that will not misinform. With flaws therefore inherent, necessary exposure and required modifications are made to the discounted cash flow approach where necessary since valuation requires professional objectivity. Article reviews Paper title Authors Journal (including year, volume and issue) Focus of paper Key findings/ conclusions Distortion in corporate valuation: implications of capital structure changes Jacob Oded, Allen Michel and Steven P. Feinstein The Journal of managerial Finance Year:2011 Volume:37 Issue:8 How traditional discounted cash flow valuation procedures should modified for firms intending to alter the debt equity ratio. 1. Discounted cash flow valuation methods are only relevant to firms that expect no changes in debt financing rate in cases of capital structure changes 2. Using discounted cash flow valuation methods in cases of firms expecting to rebalance their debt financing rates always results in significant distortion in their valuation consequently they must use alternative valuation methods. 3. The assumption by firms that no future expected changes in the capital structure are being anticipated is very unrealistic and impractical consequently making discounted cash flow valuation methodology very utopian and theoretical. Is Cash Flow King in Valuations? Jing Liu, Doron Nissim, Jacob Thomas The Financial Analyst Journal Year:2007 Volume:63 Issue:2 Valuation based on cash flows vis-a-vis earning based valuation methods 1. Earnings per share-EPS is a better summary for valuation other than operating cash flows often used in discounted cash flow valuation. Also EPS summary is a better valuation summary compared to dividend per share based forecast. 2. The subjectivity in the results of valuation based on discounted cash flow method is as a result of assumed cash inflows used in the process. Where earnings based cash flows are used there has been a tendency towards objectivity and uniformity. Reconciling DCF Valuation Methodologies. Oded, Jacob Michel, Allen The Journal of Applied Finance Year:2007 Volume:17 Issue:2 Valuation of corporation using different methods of discounted cash flows and still achieving similar results 1. Assumption of maintenance of a fixed debt equity ratio has been the major cause of valuation differences and controversy. This assumption based on the maintenance of a constant debt rebalancing policy is very impracticable and major failure in discounted cash flows valuation systems. 2. The journal also identifies sources of discounted cash flows, discount rates used and tax shield associated with debt financing rate as major flaws in the discounted cash flow valuation methodologies. 3. All discounted cash flows methodologies will produce a similar valuation to a firm during rebalancing situation where the proposed framework involving adjustments relating to debt equity ratio, discount rates, and future cash benefits. Discounted cash flow: accounting for uncertainty Nick French, Laura Gabrielli The Journal of Property Investment and Finance Year:2005 Volume:23 Issue:1 The application of discounted cash flow methodologies to property price determination with the incorporation of uncertainty measurement variables. 1. Discounted cash flow valuation with the incorporation of uncertainty measurement by use of probability ranges tends to in achieving results of a single point estimate. 2. It is possible to incorporate uncertainty measurement using probability into the current discounted cash flow methodologies consequently addressing the original weakness. The Benefits of Hybrid Valuation Models David Jenkins The CPA Journal Year:2006 Volume:76 Issue:1 Using hybrid valuation models in order to subdue the weakness of single variable models including; income approach, asset based models and market driven models 1. The main cause of valuation discrepancies in discounted cash flow methods is the value of the future expected benefits which is usually discounted at the current rate of return for the company. 2. Using the different basis for identifying future benefits; income approach, market and asset approach independently for valuation always result in diverse valuation values for the same company. This therefore indicates the subjectivity in the area of valuation which requires uniformity for different users of valuation report. 3. Hybrid approach to identifying the future benefits unifies the two approaches; income based future cash benefits and asset based benefits thereby resulting in an objectivity and superior valuation values accuracy. The ability to incorporate all the dimensions of future benefits into one model makes hybrid approach widely acceptable and effective method. 4. Hybrid approach to valuations of corporation has been able to integrate the strengths of income and asset based valuation methods making it the most effective method. Discussion and Integration Valuation of firms and other investments has always involved the establishment of a future price of that asset consequently making the future anticipated value to be a critical variable not only for the planning purposed but also for property transfers, investment analysis and acquisition, organisation management, and loan underwriting and guarantee processes. Valuation methods’ standards of accuracy in estimating the future firm’s value has always been a highly rated process considering the consequences the firm’s value when it comes to trading either through the stock’s market, general financing arrangements or acquisition and tax liability. Discounted cash flow method of valuation has always been lauded as the most appropriate method of valuation since it gives the present value of the expected future cash benefits based on a discount rate, usually the internal rate of return of a company. According to Jenkins (2006), valuation methodologies has been the major cause of controversies amongst valuation practitioners and this has been the major cause of unending litigation and other conflict resolution processes either through the courts or arbitration. Discounted cash flow valuation methodologies have also been in the limelight attracting much criticism as accolades almost in the equal aspects. Most of the critics to these methods argue that it its results are not as accurate as it should be especially in a scenario where the discounted future cash flows is based on one variable based approach such as income only, asset only or market. Estimating the future cash flows is not the only problem as it is an area of subjectivity but also the discounted rate mainly based on an assumption of a fixed debt equity ratio for the firm over the years and into the future. The incorporation of the uncertainty measurement to the Discounted cash flow valuation model makes it realistic as it takes into account the nature of commercial environment, giving the inputs the process some degree of possibility on the their value occurrence. This will allow some form of professional subjectivity where probability indices will guide more on the results other that individual biasness. According to French (2003), the incorporation of uncertainty is a necessary framework since it addresses the area of subjectivity which has been a major flaw in discounted cash flow valuation methodologies and also brings out a realistic model simulating the true business environment. Another flaw with the discounted cash flow valuation methodologies has been in relation to the very assumption of a fixed leverage rate based on uninformed and unrealistic believe that the debt equity ratio in accompany shall not change in the firm. According to Jacob, Michel and Feinstein (2011) Capital structure changes have been associated with the growth in investment opportunities leading to transaction that have changed the debt equity ratio. This has resulted in a direct effect on discounted cash flow valuation methodology since it is based on discounting expected future cash flows net of corporation tax at the company’s weighted average cost of capital- WACC rate. This implies that with every change in capital structure, there is a consequent alteration on the discount rate consequently the foundation of discounted cash flow valuation method. It is therefore imperative that discounted cash flow valuation should incorporate discount rate adjustment relationship through the process of levering and unlevering the discount rate in relation to the changes in capital structure. Discounted cash flow valuation flaws are always inherent in the different methodologies since they assume different approaches when it comes to estimating the future cash benefits expected. Some hybrid models based on income and asset based approaches have therefore been put forward and according to Jenkins ( 2006) these approached has also addressed sufficiently the challenge of subjectivity with regards to future cash inflows. It is therefore apparently clear that valuation methods based on discounted cash flow cannot be wished away but can always be modified to circumvent its own limitations consequently making them the most favourable valuation system. In cases where future cash flows are required for only one asset, then the asset based future cash flows share be a favourable option since it considers individual assets cash inflows and liabilities. Income approach on the other hand relies mostly on the existence of historical data which can be used to forecast on the expected future cash flows. Where else in scenarios involving valuation of a set of assets involving intangible assets, neither asset approach nor income approach would be reliable consequently calling for an integrated approach mainly founded upon the strengths of the two models. According to Liu, Nissim and Thomas (2007), Cash flows based on earnings like earning per share are more reliable than assumed future cash flows from operations when it comes to valuation of a firm based on discounted future cash flows. This argument emphasizes on the identification on the right future cash flow in order to derive an objective valuation of firm. Other flaws and areas of subjectivity with regards to discounted cash flow valuation are the determination of the terminal value especially for a firm which is always assumed to be a going concern, striking a balance between the deliberate tax reduction strategies and the risk of tax avoidance and in some cases; determination of the cost of capital of a firm (Liu, Thomas &Nissim, 2007). All in all the literature have given insights to the different approached to the flaws inherent in the discount cash flow valuation consequently indicating that the limitations of the methodologies can only be solved through flexible attention to the nature of the valuation problem where appropriate adjustments are done in order to circumvent the potential failures of traditional approach. References French, N, Gabrielli, L,2005, ‘Discounted cash flow: accounting for uncertainty’, Journal of Property Investment & Finance, Vol. 23, no: 1, pp.75 – 89 Jacob O, Allen M & Feinstein, P 2011, ‘Distortion in corporate valuation: implications of capital structure changes’, Managerial Finance, Vol. 37, no: 8, pp.681 - 696 Jenkins, K 2006, 'The Benefits of Hybrid Valuation Models', The CPA journal (1975), 0732-8435, vol. 76, Issue 1, p 48, Liu, J, Thomas, H, Nissim, D, 2007. 'Is Cash Flow King in Valuations?' , Financial analysts journal, vol. 63, no. 2, p 56, Wright, 2004. 'Property Valuation Methodology', The Appraisal journal, vol. 72, no. 3, p 274, Read More