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The Limitations of a Popular Valuation Tool Which Investors Must Know: Part 2

In this three part series on the limitations of a discounted cash flow (DCF) model, I’m looking at some of the more common limitations and how investors could navigate past them. In here, I’ll delve into the problems an investor might face when trying to value a distressed company or a company that’s going through some restructuring. You can read about parts 1 and 3 in here and here, respectively.

Limitation No.2: Distressed companies are not particularly suited for valuation using a DCF model

The discounted cash flow model is workable only when there is positive cash flow to speak of. This becomes a problem when we are looking at distressed companies. As the term ‘distressed’ suggests, such companies are facing some operational issues and are likely to have negative cash flow. In such cases, a DCF model will not be particularly useful. Even when the company is expected to return to profitability, very slight tweaks in assumptions on the cash flows that can be earned after the company becomes profitable again can alter the valuation of a company greatly.

We could use the shipping firm Neptune Orient Lines (SGX: N03) as an example. The company’s profits have been under pressure for a number of years now. Recently, the company was even in danger of being placed in a Watch List that’s maintained by stock exchange operator and regulator, the Singapore Exchange; NOL had suffered three consecutive years of pre-tax losses, thus meeting one of the criteria for SGX’s Watch List.

Given its circumstances, the company had struggled to even produce positive operating cash flow. Thus, it would be extremely difficult for an investor to value NOL based on its free cash flow, rendering the DCF model somewhat useless.

Limitation No.3: Companies undergo restructuring are also not particularly suited for valuation using a DCF model

One of the main assumptions that go into a DCF model is that the company in question will continue to be in the same business throughout its lifetime. However, such an event is actually quite unlikely even for a stable company; for companies going through a restructuring process – such as a large sale of assets or an acquisition of new businesses that might significantly alter the company’s future earnings potential – it is even more improbable. Therefore, if investors are using the company’s historical data as a basis for judgement of its future, the valuation model would be irrelevant as the nature of the company’s ability to generate cash flow might have been changed dramatically.

Foolish Summary

When valuing distressed companies, we need to understand that any forecasts we make of future cash flows are likely to be highly inaccurate. In this way, we could perhaps compensate by allowing the valuation model to spit out an estimated value for a distressed company that has a much larger range than normal. Similarly for companies going through a restructuring, understanding the future cash flow characteristics of the business might be a huge challenge for investors.

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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 writer Stanley Lim doesn’t own shares in any companies mentioned.