The Limitations of a Popular Valuation Tool Which Investors Must Know: Part 3

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 can work around them. In our third and last series on this topic, I’ll be touching on salient points investors should be looking out for when valuing two types of companies: serial acquirers and ones with low operational efficiencies. Part 1’s found here, while Part 2’s in here.

Limitation No.4: A DCF model’s hard to work on aggressive acquirers

A company can either grow organically (by increasing its sales or improving its efficiency) or through mergers & acquisitions. For a company that grows through the latter, there are two main issues when it comes to valuing them using a DCF model.

On the positive side, there might be synergies that come with the merger of two companies. In such an instance, the resulting cash flow production from the combined outfit might be greater than the sum of its parts. The magnitude of increase might even be underestimated, thus resulting in investors under-valuing such a company.

On the other hand, mergers might not run smoothly all the time. Sometimes, with a new management team and company culture introduced into the acquired-target, a clash in cultures can occur and eventually end up destroying the earnings of the combined entity. In such cases, investors might overvalue a company by underestimating issues related to the difficulties in consolidating the operations of two different companies.

Commodities trader Olam International (SGX: O32) is a company that had used mergers and acquisitions as a means to expand in the past. In the process, it helped introduce more variables and assumptions that investors would have to think through when trying to value the company. This has perhaps resulted in divisive views within the investment community regarding the strength of the company’s business.

In late 2012, the validity of Olam International’s business model was called into question by investment research firm Muddy Waters. The firm, a short-seller, claimed that Olam International had been facing huge problems when trying to integrate its acquired targets; Muddy Waters had even pegged the value of Olam International’s shares at close to zero . Meanwhile, Temasek Holdings (Singapore’s S$200 billion investment giant), believing that there’s value in Olam International, had stepped up its interest in the commodities outfit recently by offering to scoop up more shares of it at S$2.23 each.

Limitation No.5: Companies with low efficiencies

Lastly, companies need assets to help them earn a return. However, there are just some companies that are somehow incapable of fully utilising the earnings power of their assets. In such an instance, there can be a mismatch of expectations between what investors think the company’s capable of – by assuming its operational efficiencies can eventually match those of similar competitors – and what the company would actually churn out.

This can be dangerous for investors as it’s easy to crunch the numbers and produce a valuation that’s too high for such a company.

Foolish Summary

Although there are some inherent limitations in a DCF model that would always remain, it is still one of the most commonly-practiced forms of valuation as it is a flexible method that allows investors to tweak it to fit different circumstances.

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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.