analysisisalmostneverdone, withanalystssettling foran
expectedvalueforeachvariable(revenuegrowth,operating
margin, tax rate, etc.) that determines cash flows. In the
process, we do expose ourselves to the following errors:
- Some analysts use “best case” or “conservative”
estimatesinsteadoftrueexpectedvaluesforthecash
flows. With the former they willoverestimate the
value, and with the latter they will underestimate
value. - Evenanalystswhoclaimtouseexpectedcashflows
oftenfailtoconsiderthefullrangeofoutcomes.For
instance, many valuations of publicly traded firms
seem to be based only on cash flows if the firm
continuesasagoingconcernanddonotfactorinthe
very real possibility that the firm may cease
operations.Theresultingexpectedcashflowswillbe
overstated, as will the values of firms with a
significant likelihood of distress. - Managerscanalterthewaytheyrunbusinessesafter
observing what occurs in the real world; an oil
company willadjust explorationand production to
reflectthepriceofoilineachperiod.Sinceanalysts
havetoestimatetheexpectedcashflowsinallfuture
periods,itisdifficulttobuildthislearningintothe
model.Thisiswhyreal-optionspractitionersbelieve
thatdiscountedcashflowvaluations,evendoneright,
understate the values of businesses where this
learning has significant value.
Insummary,theexpectedcashflowapproachissimpleand
surprisingly powerful (when used correctly),but itis also
easily manipulated and misused.