Issues in relation to discounted cash flow valuation

J. Singh, Shigufta Uzma
2010 American Journal of Social and Management Sciences  
The current era of "convergence through connectivity" is slowly but certainly acknowledging the contribution of the so-called "intangibles" like brands, copyrights & patents, human & intellectual capital etc. to the bottomlines of companies. As an obvious corollary, issues relating to the valuation of such assets are surfacing with unprecedented regularity. Valuation of such assets posits an intriguing challenge for the accounting fraternity that is entrenched in the traditional ascendancy of
more » ... nal ascendancy of "reliability" over "relevance". "Discounted Cash Flow" is ubiquitous in financial valuation. In fact, this technique constitutes the cornerstone of contemporary valuation theory. The robustness of the model as well as its compatibility with the conventional two dimensional risk-return framework of investment appraisal make it immensely suited to a multitude of asset/liability valuations. Accounting standards across the globe recognize the efficacy of this model and advocate its use, wherever practicable. FAS 141 & 142 of the United States & IAS 39 that relate to the accounting of intangible assets also recommend use of DCF methodology for imputing a value to such assets. FAS 157 read with Concept Paper 7 mandate its use for ascertaining "fair value" of assets in certain cases. It is pertinent to note that the usual option pricing methods (including Black Scholes) also make use of discounted cash flows for calculating instantaneous option premia. However, like all models, DCF is not without its flaws. The model presupposes the existence of several unrealistic and rigid assumptions including, in particular, the existence of an acceptable "measure of risk" which is such that it can be integrated with the "discount" rate. In this article, we attempt to address all these issues. We start by highlighting the versatility of the DCF technique, how it can be adapted to value (literally) any asset/investment e.g. securities, projects, corporates and, now, intangibles as well. This enables us to perform a dissection of this model and adduce its anatomy. While on this, we also propose to explore interrelationships of DCF with other extant methods of valuations that include income multipliers, residual income, accrual accounting based methods etc. In today's world of "fly by night" corporate operators, it is paramount to examine the susceptibility of a model to manipulations, and we also examine this facet of the DCF model by conducting a comprehensive sensitivity analysis with respect to the input variables that include estimated/projected cash flows, discount rates, horizon values, the existence of abandonment options etc. As is inevitable, the DCF methodology has its own spectrum of limitations. While concluding this article, we present some of the important shortcomings of this model and make recommendations on its possible upgradations to enhance its efficacy and reliability.
doi:10.5251/ajsms.2010. fatcat:iy6n7p5eordqfnowg42ikspmky