Hi all. The CFAI text (Reading 32) describes the methodology for valuing a M&A target company using the discounted cash flow method in two stages: 1. a). Determine a forward time horizon over which it is reasonable to estimate free cash flows b). Discount them and calculate the NPVs. c). The result is a stage 1 valuation. 2. a). Estimate the terminal value of the free cash flows for the period beyond the reasonable horizon. b). Discount that value. c). The result is a stage 2 valuation. The text then describes the sum of stage 1 and stage 2 values as the value of the target firm. My question is: There will usually be an element of Net Book Value (or equity) already present in the target company, so shouldn’t this be included as part of the valuation process somewhere? The text (as far as I’ve read) doesn’t say anything about how this aspect is treated. Thanks in advance.
I would imagine that unless in extreme cases, the amount of equity or NBV of the company is not really considered. If you look at a company that you want to buy, the DCF is used to determine whether the investment is a good opportunity for generating income, not necessarily making Capital Gains profit, no? But I see your point. Company A DCF gives $40,000 and the company has $1 Billion in Equity versus Company B DCF $100,000 and B has $10 of equity. Looking at it like this makes me think that if you have a higher amount of equity ($1B) and can’t use it to generate more income/value, maybe its not the best investment. Also, Company A ($1B) may only have a DCF Value of $40,000, but with its equity in place, wouldn’t it sell for $1B 40Kish? In this case, I would accept the Company B. I don’t know how much this helps, but it was a good review for me on DCF at least.
I understand that you need to only consider positive NPVs when making your investment choice, and then select the optimal combination of project. But my question is more to do with teh method for company valuation once that decision is taken. If the equity in the target company is not included in the valuation, surely you are arriving at a valuation that is too cheap?
No, DCF as a role is to generate a valuation of the stock price based on the company cash flows coming in on a ten year period. Equity is not relevant in this calculation
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