John asked in Business & FinanceInvesting · 8 years ago

Why doesn't DCF analysis also take shareholders' equity into account?

Let's assume company X has free cash flows of $1,000 per year for the next few years (never mind WACC and the growth rate for the sake of this example) and a similarly low terminal value. Theoretically, even if shareholders' equity is $1 million (let's say your only asset is a million-dollar building with no mortgage on it), the company would only be worth about $10,000 under a DCF analysis. I know this scenario is unlikely, but even under more reasonable circumstances, there could be considerable discrepancies between a company's value based solely on its projected cash flows and its value base on cash flows AND equity.

So my question is basically why doesn't this highly popular method take equity into account and why don't any valuation models I know of (comparables, precedent transactions and LBO) directly take a company's hard assets/equity into account in determining a value? Thanks a lot

Update:

by the way, I'm no expert.. by all means correct me if I'm wrong in anything I said

Update 2:

"THEORETICALLY." I used it as an extreme example

"I know this scenario is unlikely, but even under more reasonable circumstances"

geez...

1 Answer

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  • JoeyV
    Lv 7
    8 years ago
    Favorite Answer

    It would mean that the company's ROE was completely pitiful and the company was grossly mismanaged. Using DCF analysis would just be inappropriate. This company is worth way more as a takeover target or a liquidation. The own a $1M building and the best they can do is rent it out for $1000/year? What kind of idiocy is that?

    Edit: I know that you are using it as an extreme example - the point is that your thinking about discounted cash flow analysis is wrong. Cash flows include sales of assets. If you have an asset that can be sold for more than the discounted cash flow then you should sell the asset. If you have a company that isn't doing that, then you should fire management. That's one of the things that shareholder activists do.

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