Common Valuation Errors: The DCF Methodology

The Michel-Shaked Group’s Luka Miladinovic and Brad Orelowitz published an article in the November 2024 issue of the American Bankruptcy Institute Journal discussing common valuation mistakes related to the Discounted Cash Flow (“DCF”) methodology. Specifically, the article describes the most common errors that occur during the derivation of the unlevered free cash flows.

The DCF analysis is an income-based valuation approach and is one of the most widely utilized valuation methodologies. However, despite its wide-spread utilization, there is a set of recurring mistakes that are made by valuation practitioners. A DCF analysis aims to determine the unlevered free cash flows over the projection period, and discount them back to the present value based on an appropriate discount rate. However, calculating the unlevered free cash flows turns out to be more challenging than anticipated, as evidence by the frequency of common errors made in the process.

In particular, this article explains the proper way of calculating the unlevered free cash flows, covering the treatment of stock-based compensation expense and one-time expenses, correctly projecting changes in net working capital, as well as the importance of avoiding double-counting the same cash flow adjustments. The DCF analysis is very sensitive to changes in the unlevered free cash flows, which is the reason why seemingly trivial mistakes made during the valuation could result in drastic changes in a derived value of a company or an asset. Thus, the authors of this article provide a framework that could be employed when determining the unlevered free cash flows to prevent common valuation errors.

A full version of this article can be seen here.