Setting fair value and the meaning of DCF

How to determine fair value of company?

Fair value of company should be determined using different kinds of multiples such as P/E, P/BV and EV/EBITDA, development of sales and profitable and for some part DCF model. Multi-criteria Rankings is an excellent tool for determining fair value of company. Value of company should always be compared among its peers and competitors and also the current level of valuation in overall markets.

Reality check using DCF fair value

DCF is at its best when it is used as a reality check as it should be. With DCF you can see what would actually be demanded in certain price - expectations considering growth, profitability and their development. Had this been used in the end of the roaring nineties the outcome could have been different. Still DCF is not an absolute truth and should never be used without other methods.

Anyway the reality check with DCF is strongly recommended. If the difference between DCF fair value and the fair value you determined earlier is acceptable, you can continue to next step. If there is a significant difference between these levels, you should recheck your expectations.

Adjusting DCF to support your target price

After the reality check DCF can be modified to support and justify your fair value. Do not modify DCF before you have really thought about realistic fair value of the company and determined your target price - it would be useless and misleading. Adjusting DCF can be done best e.g. by changing parameters such as mid-term growth and profitability: Net Sales growth and Ebit-% estimates. By mid-term we mean e.g years 3-7 from current year. If you slow down the current perhaps rapid growth towards the terminal value or decrease profitability faster than the previous estimates you also decrease fair value. If you increase growth and profitability (or preferably make them decrease in a slower pace towards the terminal value) then you increase terminal value. The terminal values themselves should not be manipulated much.

Most recommended way is to use net sales and EBIT parameters, as all the other estimate parameters should be rather constant: there is not much sense in changing the average depreciation-% or changing the working capital or investments as there are normally only one reasonable level. Also WACC parameters are rather constant so they should not be manipulated much. if you have big problems on adjusting DCF fair value to your fair value, check your estimates once again. Investors (customers) are able to see, as they should be, what your estimates are based on. They can see your growth and profitability estimates easily. Remember this when you are justifying your target price / fair value - and never try to justify something that just is not there.