The debate of whether discounted cash flows or peer group comparisons are the better business model has raged ever since M&A became vogue. Let me put an end to the suspense right now: both are useless as effective valuation tools. Let’s find out why and what might work.
Discounted Cash Flow
The problem with discounted cash flows (DCF) is the sensitivity to a large number of parameters especially since DCF is usually used to predict high-growth. It is hard enough to predict the future performance of stable businesses. Trying to predict the performance of companies in a growth phase is indistinguishable from guessing.
So how should you go about valuing the company that is about to go into a high-growth phase? The short answer is you use a value based on the scenario that the company continues as is. In other words the high-growth is as much a result of your cash as it is of the company’s business. Therefore the growth phase piece should be treated as if it is a complete start-up where everything is valued at book value and therefore there is no premium on the current business.
Peer Group Comparison
Peer group comparison is quite possibly the most ludicrous valuation method that I have seen. What peer group comparison does is compare the price of the target company with its peers. Valuation absolutely does not make an appearance.
I therefore have found it quite useful to use peer group comparison during a bear market as it gives a valuation that is usually relatively low, but try to eschew it during a bull market.
The uselessness of peer group comparison does not end with the price — value gap. Market price comparisons make sense when comparing the exact same product. For example when you wish to buy a second-hand Land Cruiser then what you do is look for the market price of the same make, year and mileage. What you don’t do is look at the price of a Range Rover, Jeep and a G-Wagon for some kind of guidance to the price of the Land Cruiser.
So what’s the answer? Look at the current business and how it is performing, compare it to historical performance to ensure that previous performance in the short term is not an anomaly, and then assume growth will match that of the market.
Yes, such an approach would lead you to miss the high-growth companies. But here’s a secret: you will always miss the high-growth companies. At least this approach ensures you don’t overpay for the good companies.
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