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The Limitations of a Popular Valuation Tool Which Investors Must Know: Part 1

Valuing a company using a discounted cash flow (DCF) model is extremely useful. It allows us to focus on a company’s ability to generate cash and helps steer us away from companies that can only produce large “paper profits” – i.e. companies that can’t seem to generate sufficient cash despite being very profitable from an accounting stand point.

However, every tool has its limitations and if a DCF is not used properly, it can create painful mistakes for investors. In this three part series, I’ll be looking into some of the more common limitations of the DCF model and how investors can work around them. You can read about parts 2 and 3 in here and here, respectively.

Limitation No.1: A DCF model is not suitable for cyclical companies

By the nature of their businesses, cyclical companies tend to have volatile earnings over the whole boom-and-bust of its business cycle. Therefore if we try to project the cash flows earned by a cyclical company during boom times, we might obtain an unrealistically high valuation for the company. Similarly if we value the company only based on its earnings (or losses) during its down-cycle, it might result in a very low valuation.

One good example of when we might make such a mistake is with a company like public-transport outfit SMRT Corporation (SGX: S53). At first glance, SMRT might not be your typical cyclical company since after all, it operates in a regulated industry with only one other competitor. However, the heavy regulations in the public transport industry have helped induce cyclicality into the nature of the company’s business. This is borne out in the company’s financials: SMRT started with a net profit of S$89.5million in 2004; grew it to around S$160million in the period from 2009 to 2011; and ended 2013 with profits of only S$83.3 million.

In 2010 when it was posting good results, SMRT had generated a free cash flow of around S$240 million. However, when the company faced harder times, like in 2013, it only managed to record a free cash flow of around S$12million. Depending on which cash flow figure you had used (2010’s or 2013’s) as a baseline, it’s easy to see how a huge difference in valuations might result.

Foolish Summary

No tool is without flaws. However, once we know the limitations inherent in a DCF model, we can adjust it for different scenarios so as to make the valuation process relevant again. In the case of a cyclical company, it would be better to use an average of its free cash flow figure over a business cycle as the baseline when computing its value.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.