The discounted cash flow (‘DCF’) method, a widely used method under the Income Approach, has always served an important role in increasing the transparency of a valuation analysis. As more detail from the valuation professional is required as standard, the DCF often satisfies stakeholder requirements. During this current period of uncertainty, though, the use of the DCF as the leading valuation method has become even more relevant. For example, as we see limited partners (‘LPs’) of private equity funds requesting increasingly more detail on the valuations of portfolio companies, often derived under the Market Approach, general partners (‘GPs’) may only be able to meet this request by supporting the valuation using the DCF method.
Generally, the DCF method is applied first by deriving the ‘single most likely cash flow projection’ and subsequently discounting this projection back in time to the valuation date. It is commonly accepted, though, that in times of uncertainty such as now, the derivation of a single scenario is much less supportable than the use of multiple likely cash flow scenarios, weighted by their relative probability of materialising.
This so-called ‘probability weighted DCF method’ has been in use by many, including KPMG, for years in other uncertain environments, including past economic crises as well as frequently in the notoriously uncertain pharmaceutical sector. As this method often offers the highest level of transparency among those available, we find it now more than ever, the most appropriate valuation method going forward under current conditions.
Read more in our latest “Quarterly Brief” newsletter and register now to get the next edition.