What the Textbooks Miss in Valuation Practice (Part 2)
The DCF Trap: When Perfect Math Meets Imperfect Reality
DCF might look great in a textbook, but in real life? It can be a bit of a trap. It’s built entirely on forecasted assumptions, and you know how that goes. Especially in M&A, where the seller is probably handing you a forecast that’s, let’s say, optimistically inflated.
Take a business generating $500 in free cash flow. Using an 8% growth rate and a 10% discount rate, you get a DCF of $23,310. Change those assumptions by just 1%, and the valuation can drop by half. The model is only as good as the guesswork behind it.
Why Comparable Transactions Are the Real MVP
This is why I lean on comparable transactions. They provide a sanity check against market reality. If DCF is the theory, comparables are the antidote. They help you understand the range of multiples in similar deals and adjust for qualitative factors like market potential and risk.
But here’s the rub: In high capex industries, EBITDA multiples can be misleading. Two businesses with the same EBITDA might have very different capital needs. The solution? Use EBITDA less recurring capex as your metric. It’s a closer proxy to real cash flow and a much better basis for valuation.
Synergies: The Good, The Bad, and The Ugly
When it comes to synergies—the supposed magic that creates deal value—always separate the hard synergies (quantifiable and reliable) from the soft ones (more like wishful thinking). You might share some hard synergies with the seller in a competitive bid, but never, ever bake soft synergies into your valuation offer. That’s a recipe for disaster.
The Reverse DCF: A Real-World Application
While I’m not a huge fan of DCF in traditional scenarios, I do like using a reverse DCF to validate valuations. You start with a market-based valuation, then work backward to see what growth and discount rate assumptions it implies. It’s a great way to test whether your assumptions are grounded in reality.
Practical Steps for Valuing a Business
Alright, let’s wrap this up with a practical framework I use:
- Understand the acquisition perimeter – What exactly are you buying?
- Break down the business into cash-generating units – Separate profit-makers from loss-makers.
- Choose your valuation method – Earnings-based or asset-based.
- Apply the right multiples – Use comparables, adjust for capex needs, and ensure your assumptions make sense.
- Backtest with a reverse DCF – This is your reality check.
- Include hard synergies only – And decide how much of that value to include in your offer.
So, What’s the Bottom Line?
Valuation is messy. It’s part art, part science, and part gut feeling. The smartest deals I’ve seen are the ones where the price is so good, the details almost don’t matter. When you buy well, you create a margin of safety that smooths over any miscalculations.
But hey, that’s just my take. What’s been your experience with valuation? Have you seen deals where the “textbook” approach fell short? come email uncle at TalkTo@UncleHuat.com