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Reconciling Relative and Discounted Cash Flow Valuation

Both relative valuation and discounted cash flow (DCF) valuation are valuable tools, but they often yield different results. Understanding the reasons for these differences and how to reconcile them is crucial for arriving at a well-informed valuation conclusion.

1. Understanding the Differences:

  • DCF Valuation:
    • Focus: Intrinsic value. Estimates the value of an asset based on its expected future cash flows, discounted at a rate that reflects its riskiness.
    • Bottom-Up Approach: Starts with the company's fundamentals (e.g., revenue growth, profit margins, capital expenditures) and builds up to a valuation.
    • Long-Term Perspective: Emphasizes long-term cash flow generation and sustainable competitive advantages.
  • Relative Valuation:
    • Focus: Market value. Estimates the value of an asset based on how the market is pricing comparable assets.
    • Top-Down Approach: Starts with market multiples and applies them to the target company.
    • Short-Term Perspective: Reflects current market sentiment and pricing, which can be influenced by short-term factors.

2. Reasons for Differences in Valuation:

  • Market Mispricing: The market may be mispricing comparable assets, leading to an inaccurate relative valuation.
  • Incorrect Comparables: The selected comparable companies may not be truly comparable to the target company, leading to an inaccurate relative valuation.
  • Inaccurate Forecasts: The assumptions used in the DCF valuation (e.g., growth rates, discount rate) may be inaccurate, leading to an inaccurate DCF valuation.
  • Different Time Horizons: DCF valuation focuses on long-term cash flows, while relative valuation reflects current market conditions.
  • Market Sentiment: Relative valuation is heavily influenced by market sentiment and investor psychology, which can be irrational and unpredictable.
  • Control Premiums: M&A deals often involve control premiums, meaning the acquirer pays more than the current market price to gain control of the target company. Relative valuation based on transaction multiples may reflect these control premiums, while DCF valuation does not.
  • Illiquidity Discount: DCF may be more realistic when the company is illiquid.

3. Steps to Reconcile the Valuations:

  • Review Assumptions: Carefully review the assumptions used in both the DCF valuation and the relative valuation. Identify any assumptions that are significantly different and assess whether they are justified.
  • Refine Comparables: Re-evaluate the selection of comparable companies. Ensure that the comparables are truly similar to the target company in terms of industry, business model, risk profile, and growth prospects.
  • Adjust for Differences: Adjust the multiples of the comparable companies to account for any significant differences between them and the target company.
  • Consider Market Sentiment: Assess the current market sentiment and determine whether it is likely to be influencing the relative valuation.
  • Focus on Key Drivers: Identify the key drivers of value for both the target company and the comparable companies. Ensure that these drivers are adequately reflected in both the DCF valuation and the relative valuation.
  • Use a Range of Values: Recognize that valuation is not an exact science and consider a range of values based on different valuation methods and assumptions.
  • Weighting: Use a weighting scheme that reflects the strengths and weaknesses of each method in this specific situation.

4. Techniques for Reconciliation:

  • Implied Growth Rate: Use the Gordon Growth Model (or a similar model) to calculate the implied growth rate embedded in the market multiple. Compare this implied growth rate to the company's expected growth rate. If there is a significant difference, investigate the reasons for the discrepancy.
  • Sensitivity Analysis: Perform sensitivity analysis on both the DCF valuation and the relative valuation to assess the impact of different assumptions on the valuation results.
  • Scenario Planning: Develop multiple scenarios (e.g., best-case, worst-case, base-case) and value the company under each scenario using both DCF valuation and relative valuation.
  • Adjust Multiples for Growth: Use growth-adjusted multiples (e.g., PEG ratio) to account for differences in growth rates between companies.
  • Calculate Residual Income: A hybrid model where you discount near-term cash flows, but rely more on longer term market-based expectations.

5. When to Favor One Method Over the Other:

  • DCF Valuation:
    • When valuing companies with unique characteristics or limited comparable data.
    • When taking a long-term investment perspective.
    • When control and/or synergies are factors.
  • Relative Valuation:
    • When valuing companies in mature industries with plenty of comparable data.
    • When taking a short-term, market-oriented perspective.
    • When wanting a "market check" on your DCF model.

By understanding the differences between relative valuation and DCF valuation and taking steps to reconcile the results, you can arrive at a more robust and reliable valuation conclusion. The best valuation practice often involves using both methods and understanding why they differ.

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