I just read two recent articles on EBITDA.


  1. https://www.toptal.com/finance/financial-analysts/ebitda?utm_source=linkedin&utm_medium=HBR&utm_campaign=EBITDA


2. https://www.toptal.com/finance/financial-analysts/ebitda?utm_source=linkedin&utm_medium=HBR&utm_campaign=EBITDA

Quite interesting to see how EBITDA got challenged though it is used widely in the valuation. EBITDA so far is still seen as a clean measure of what the business has generated, separate from its capital or financing structure and investment. Since we are more interested in the risk of the company’s underlying business operations, then EBITDA seems to me, is relevant to use.


Comments from Ignacio Velez-Pareja:

You might guess what I think of EBITDA.

First of all, I prefer to show THREE financial statements: CB, P&L and BS.

When you do that, you have the best shortcut to CF: CCF = CFD+CFE and these two are seen directly in the CB as the negative of the financing module (3) and the equity transactions module (4). That’s it.

I think that valuation by multiples is still a questionable.

I do calculate multiples just to compare the calculated value with real transactions, not the contrary. I mean, multiple calculation should be done AFTER, valuation (DCF) in order to be compared with similar transactions. I just remember one firm that approached us saying that they were offered to buy the firm by 7 x EBITDA and asked if we could give an opinion on that. We said we had NFI if it was good or not to sell it to the English firm that made the offer. We explained the idea of DCF and that after that we could give our opinion. In short, we valuated the firm, we were very critical and conservative to any input to be included, such as real growth rates and real price increases and we found that EV/EBITDA might range between 12-17. After a couple of years I met the owners and they told me they didn’t accept the offer and that our estimate of multiple was still conservative. They were very happy with their decision not to sell.

Regarding the terminal value, TV, yes, it might be a Pandora’s Box. We usually have 3 estimates for TV: Invested Capital at year N, non-growing perpetuity and growing perpetuity. We try that PV(TV) is around 20%-30% of EV.

Bottom line: I stick to DCF.

Best regards

Note from Karnen: DCF is of course, the most “technical” analysis, compared to the other techniques in the Valuation for M&A, they are Comps and Precedent Transactions. However, the necessity to use Perpetuity in the DCF analysis is still quite problematic as it could take as much as 80% of the Enterprise Value analysis.

IPO Valuation – A Quick Communication with Prof. Peter M. DeMarzo (Stanford Graduate School of Business, USA)

Hi Prof. Peter,

I am referring to the 4th Edition of the Corporate Finance textbook (https://www.amazon.com/Corporate-Finance-4th-Pearson-Standalone/dp/013408327X),

Chapter 23 under 23.2 “The Initial Public Offering”, section “valuation” which said:

Before the offer price is set, the underwriters work closely with the company to come up with a price range that they believe provides a reasonable valuation for the firm using the techniques described in Chapter 9. As we pointed out in that chapter, there are two ways to value a company: estimate the future cash flows and compute the present value, or estimate the value by examining comparable companies. Most underwriters use both techniques. However, when these techniques give substantially different answers, they often rely on comparables based on recent IPOs.

However, when looking into Chapter 9, I do not find any mention about pre-money and post-money valuation.

Normally, for IPO purposes, since the company is going to issue new shares to be offered to the public, instead of the existing shareholders selling their shares to the public (Note: they could do so, post IPO, and there could be a lock-up period, let’s say, one year in certain country, for existing shareholder to be not being able to sell their shares), it is important to see how much the value of the company before and after the IPO proceeds flowing into the company’s bank account. The planned use of the IPO proceeds will be required to be disclosed in the prospectus and this will impact the IPO valuation, as the analyst needs to assess how much the added value of that use to the whole valuation.


The reply from Prof. Peter

Hi Karnen,

Yes, it is a good point worth mentioning that the value will be based on the anticipated future cash flows given any new investment.  (Alternatively, the new cash raised will contribute to the equity value over and above existing enterprise value.)

Thanks again,



Karnen’s responses:

Hi Prof. Peter,

This IPO valuation (or pricing in reality in view of limited number of shares being put on offer for sales to the public, resulting in the working of demand and supply law) is really interesting, though I see the Corporate Finance textbook is quite little in bringing to really appreciate it.

This IPO pricing is essentially about what the company would like to do with the IPO proceeds.

In general, we could separate the use of that IPO proceeds into:

  1. Financing a project/business totally separated from the company’s existing projects/business.
  2. Financing/refinancing current business, for example, the expansion in the same business line (opening more stores, financing working capital, capital expenditures), and/or paying down the bank loans
  3. The combination of No. 1 and No. 2 above.

In the case of No. 1 above, and assuming there is no positive/negative synergy with the current business/project, then the IPO pricing will really look into the added value (=NPV) of that new ventures divided by the number of newly issued shares.

In the case of No. 2 above, then we need to look at the equity value after being added with the NPV brought in by the expansion, etc., after factored into the valuation, the plus and minus of the synergy value. As a note, the NPV of the project will ultimately go to the equity shareholders or investors (Note: NPV project = NPV investors only holds if market value of the debt is identical to book value of the debt. If the debt is traded one, such as bonds, then this could not hold). Then the IPO pricing is the new equity value divided by the total number of common shares (current shares + new shares).

Jakarta, August 2017



I have made 5 videos showing the consistent formulas that we need to use for Tax Shield discount rate, Ke (Cost of Levered Equity), which will give us the same computed value result.

In those videos, I use the assumption of TS discount rate being discounted at Ku (Cost of Unlevered Equity).

In a nutshell, we need to be consistent in which formulas to use..otherwise, the resulted value will not be the same…trust me!

Kd that should be used in the WACC for CCF Kd WITHOUT (1-Tax). Once we apply this, it is so easy to see that the WACC is now Ku….. This is why Ignacio Velez-Pareja (the co-author of the Principles of Cash Flows Valuation book) kept saying that the simplest thing to do the valuation if we don’t have much time, we just apply Ku as the discount rate to CCF.

No circularity….and we have more time to focus on building the better forecast for FCF and TS.

Now I could see WACC applied to FCF is not the best option…easily leading to incorrect TS which might not always be there for the company at tax loss situation, and the constant leverage assumed.

Notes from Ignacio Velez-Pareja: (Note: I put in italics)

For clearness, when you wish to use the name WACC. it is better to say WACC for the FCF or for the CCF. For Ku as discount rate for TS, in the first case, it is Kd(1-T)D%+KeP% or BETTER, Ku-TS_t/V-t-1. Please throw out the first formula for WACC for the FCF to the trash. In the second case, CCF, WACC is Ku = KdD%+KeE%. Throw out the last formula  to the trash. Just use Ku and that’s all.

We have 5 methods: 3 of them have circularity and 2 don’t. No circularity: APV and PV of CCF at Ku. Circularity: PV of CFE at Ke, “general ” WACC and textbook WACC. 

You are 100% right when you say that using Ku and CCF gives you time to devote to make a better forecast and models. 

Please notice that Ku = KdD%+KeE% is true ONLY when Ku is the discount rate for TS. Look at the other tabs/sheets for other discount rates (Kd, Ke or any number) and see the formulas you have worked on in the case of Ku as discount rate of TS and the others. Try calculating Ku = KdD%+KeE% for each case and you will notice that the ONLY case when it is identical to Ku is when Ku is the discount rate for the TS.

In the literature, it seems to me that people mix cases (discount rate for TS) even for perpetuities. For perpetuities, the case of Ke is as follows:

  1. For Ku Ke = Ku + (Ku-Kd)D/E for finite cash flows AND perpetuities.
  2. For Kd, in general, and for finite CFs: Ke= Ku + (Ku-Kd)[Dt-1/Et-1 – VTSt-1/ Et-1] .  For perpetuities. remember that VTS = KdDT/Kd=DT, hence, Ke= Ku + (Ku-Kd)[Dt-1/Et-1 – (KdDT/Kd)t-1/ Et-1] = Ku + (Ku-Kd)[Dt-1/Et-1 – (DT)t-1/ Et-1]. And then you have the popular Ke formulation for perpetuity (that many wrongly use for finite CFs): Ke= Ku + (Ku-Kd)[Dt-1/Et-1 – (KdDT/Kd)t-1/ Et-1] = Ku + (Ku-Kd)(1-T)Dt-1/Et-1
  3. Those many that use (or used) Ke=Ku + (Ku-Kd)(1-T)Dt-1/Et-1 were authors such as Brealey and Myers, just to mention one pair of Holy Cows in finance books. 


Back to my videos, in the next videos, I will use the TS discount rate at Kd (Cost of Debt).





Pengadilan Pajak di California, Amerika Serikat yang melibatkan harta kekayaan (Alm.) Michael Jackson antara Estate of Michael J. Jackson (Deceased) (selanjutnya diacu Estate saja) dengan Kantor Pajak Amerika Serikat (the Internal Revenue Service, atau disingkat IRS) menarik perhatian terkait nilai pasar wajar dari hak publisitas (right of publicity) almarhum mencakup nama dan citranya.

Sebagai latar belakang case ini bisa dibaca di tulisan Robert W. Wood berjudul “Even After Death, Michael Jackson Has to Deal with the IRS”.

http://www.americanbar.org/publications/blt/2013/10/03_wood.html (diakses pada tanggal 18 Februari 2017).

Bahkan Blomberg menurunkan satu artikel pada tanggal 1 Februari 2017 menarik yang ditulis oleh Devin Leonard berjudul “Michael Jackson is Worth More Than Ever, and the IRS Wants Its Cut”, yang mengulas sengketa terkait valuasi Estate of Michael Jackson. Di sini IRS mengklaim bahwa Estate seharusnya dinilai sebesar USD 434 juta, dan bukan sebagaimana yang dinyatakan oleh Estate hanya sebesar USD 2.105. Estate mengklaim hanya nilai USD 2.015 karena pada saat wafatnya, almarhum sedang menghadapi banyak masalah skandal.

(lihat https://www.bloomberg.com/news/features/2017-02-01/michael-jackson-is-worth-more-than-ever-and-the-irs-wants-a-piece-of-it, diakses pada tanggal 18 Februari 2017)

Tulisan Michael Cohn pada tanggal 8 Februari 2017 juga membicarakan hal ini, dimana diberikan judul “Court Hears IRS Dispute over Value of Michael Jackson Estate”).

(lihat https://www.accountingtoday.com/news/court-hears-irs-dispute-over-value-of-michael-jackson-estate, diakses pada tanggal 18 Februari 2017)

Dalam prapengadilan, pihak Estate mengajukan permohonan agar pihak Pengadilan Pajak tidak menggunakan (exclude) laporan valuasi yang diterbitkan oleh ahli intellectual property Weston Anson (CONSOR) dengan pertimbangan beberapa alasan. Salah satunya, pihak ahli Anson memasukkan nilai untuk usaha yang sangat spekulatif, seperti Michael Jackson taman bermain (theme park). Namun sebagai alasan terbesar keberatan pihak Estate adalah bahwa laporan valuasi mencakup kombinasi (mash-up) dari berbagai hak (rights) yang berbeda-beda, dimana pihak Estate menyebutkan hal ini menyalahi ketentuan peraturan di Amerika Serikat bahwa setiap item intellectual property wajib dinilai secara terpisah. Kombinasi hak-hak yang berbeda-beda disebutkan meliputi nilai nama Michael J. Jackson dan foto/gambar (likeness), dan katalog hak-hak penerbitan (publishing rights), bersama-sama dengan nilai aset lainnya yang dimiliki almarhum pada saat wafatnya, yaitu hak dagang (trademarks), hak cipta (copyrights) di musik dan hak almarhum sendiri untuk menerima royalty sebagai penampil (performer).

Menarik membaca tanggapan dari hakim Pengadilan Pajak di Amerika Serikat, Mark V. Holmes yang menyatakan bahwa laporan valuasi Anson tidak seharusnya dikecualikan atau tidak dipertimbangkan.

Dikutip seutuhnya, dikatakan:

This is an especially interesting legal question. In a world without transaction costs, it wouldn’t matter if publishing rights, performance royalties, trademarks, etc. were valued separately because a rational buyer would value them as if they could be put together in the most profitable way even if they were bought separately. But it is entirely possible that trial will show that these separate rights would be more valuable if used together. If so, and if the Estate owned these separate rights, it might well be the case that they are worth more together than they would be if summed separately.

Terjemahan bebas:

Ini adalah pertanyaan legal yang cukup menarik. Dalam suatu dunia tanpa biaya transaksi (catatan: Penulis teringat dunia ideal teori M&M dalam manajemen keuangan), bahwa tidaklah menjadi masalah jika hak-hak penerbitan, royalti penampilan, hak dagang, dan lain-lain dinilai secara terpisah atau tersendiri-sendiri karena seorang pembeli yang rasional akan menilai seluruh hak-hak tersebut seakan-akan seluruh hak-hak tersebut dapat ditempatkan dan dimanfaatkan dalam cara-cara yang paling mendatangkan keuntungan, sekalipun masing-masing hak-hak tersebut diperoleh secara terpisah. Akan tetapi sangat mungkin bahwa pengadilan akan dapat menunjukkan bahwa hak-hak yang terpisah ini akan lebih berharga (atau nilai keseluruhan akan lebih tinggi) jika hak-hak tersebut dipergunakan secara bersama-sama (catatan Penulis: akan ini berarti manfaat sinergi?). Jikalau demikian, dan jika pihak Estate memang memiliki hak-hak terpisah ini, ada kemungkinan yang baik bahwa keseluruhan  hak-hak tersebut akan memiliki nilai yang lebih tinggi daripada kalau nilai masing-masing hak-hak itu dijumlah secara terpisah.


Keputusan Hakim Mark V. Holmes tertanggal 3 Februari 2017 dapat dibaca dalam lampiran tulisan ini dalam bentuk pdf.


Membicarakan manfaat “sinergi” [Catatan: pihak Akuntan punya nama tersendiri, yaitu “goodwill” untuk kehadiran sinergi?]  dalam valuasi dan kemudian berusaha memecah-mecah ke dalam masing-masing aset (baik tercatat atau tidak tercatat di neraca atau laporan posisi keuangan), merupakan tantangan tersendiri. Banyak hal-hal yang berusaha diperkenalkan oleh para ahli valuasi, terkait ini, misalnya dalam konteksi valuasi nilai korporasi atau bisnis, adanya konsep “normal or normalized earnings/margin”, “[positive, negative] abnormal earnings/margin”, “excess earnings/margin”, “competitive margin”, yang kadang bisa menimbulkan interpretasi yang berbeda-beda, termasuk data yang akan digunakan. Isu yang lain, apakah dipakai “accounting [book value] earnings/margin” atau “economic earnings/margin”?


Penulis juga teringat akan buku Determining Value: Valuation Models and Financial Statements oleh Richard Barker (Essex (England): Pearson Education Limited. 2001. Halaman 109), yang menyebutkan:


An intractable valuation problem is that this total value cannot be disaggregated across each of the assets individually. This is due to synergy between assets. A company does not create value simply by holding assets. It creates value by means of a judicious combination of expenditure decisions, in areas as diverse as recruitment, product, developments, plant construction, advertising, service delivery and operations management. It is the combined effect of each of these resource allocations that gives rise to an income stream, and thereby to a value for the company as a whole. Viewed in this way, it is unclear what the term “value” means when applied to individual assets in the balance sheet. An individual asset may have a market price, as discussed above, but its value to the company will depend inextricably upon its relationship with all other resources deployed by the company. [Catatan: bagian yang dipertebalkan, disengaja untuk penekanan].



Dari yang dikatakan oleh Richard Barker, kehadiran “sinergi” antara aset berwujud (tangible assets) dan tidak berwujud (intangible assets), dan “item yang saat ini belum teridentifikasi (oleh akuntan), yang bisa ada wujud atau tidak berwujud, namun umumnya dalam level tertentu tetap ada wujudnya, misalnya hasil print-out (unidentifiable items)” sangat krusial untuk terciptanya “nilai” (value). Walaupun secara umum dikatakan bahwa terlepas apapun item tersebut, mau diberi label, termasuk yang saat ini belum banyak diberi “nilai” dalam laporan keuangan perusahaan misalnya manajemen, proses pengambilan keputusan, sumber daya manusia, standar prosedur operasional, rantai pemasokan (supply chain), teknologi informasi, bahan-bahan dan tepat sasar program-program marketing, eksekusi program yang terarah dan terukur, namun semuanya diyakini dan memang sudah terbukti, bersama-sama, melalui hubungan dan interaksi (relationship and interaction) yang kompleks akan sangat diperlukan guna terciptanya kemampuan perusahaan atau bisnis dalam menghasilkan pendapatan (revenue), laba (earnings) dan arus kas bebas (free cash flow).


Kemampuan masing-masing item dalam memberikan kontribusi bagi terciptanya kemampuan perusahaan/bisnis mendatangkan pendapatan, laba dan arus kas bersih, niscaya justru tidak signifikan, namun melalui interaksi itulah yang menjadi kunci sangat krusial. Artinya, masing-masing item mungkin saja bernilai rendah, namun pada saat dikombinasi, di-bundle dalam suatu proses, akan mendatangkan nilai yang tinggi.


Dua diagram ini di bawah ini bisa memberikan gambaran kehadiran “hubungan/interaksi” diantara para sumber daya menurut penulis jauh lebih penting dalam penciptaan nilai.


Diagram 1: Value Map – Identifikasi Sumber Daya


Sumber: Brand Finance Plc


Diagram 2: Value Map – Pengelompokan Sumber Daya dan Menaksir Nilai Kontribusi



Sumber: Brand Finance Plc


Kedua diagram di atas diambil dari tulisan Tim Heberden berjudul Intellectual Propery Valuation and Royalty Determination (yang dimuat dalam buku berjudul International Licensing and Technology Transfer: Practice and the Law, editor Adam Liberman, Peter Chrocziel dan Russell Levin. Pemuktahiran tahun 2011 yang diterbitkan oleh Wolters Kluwer Law & Business).




Jakarta, 18 Februari 2017


US Tax Court 2017 Estate of Michael J. Jackson vs Commissioner of IRS



Pada tanggal 26 Januari 2017, dalam blog-nya, Prof. A. Damodaran (Professor of Finance dari Stern School of Business New York University) memposting suatu tulisan berjudul “January 2017 Data Update 6: A Cost of Capital Update!”


Tulisan tersebut cukup menarik untuk dibaca mengingat bahwa ada kecenderungan analis valuasi menghabiskan cukup banyak waktu berupaya untuk mendapatkan discount rate atau cost of capital yang dirasakan akan dapat mewakili profil resiko dari arus kas bisnis atau proyek yang bersangkutan, sehingga besar kemungkinan justru tidak banyak waktu untuk arus kas (=Free Cash Flow) dan laba (EBITDA, EBIT). Pertimbangan bahwa cukup dengan menganalisa data-data historis dan pembanding, akan memadai untuk mempertahankan proyeksi arus kas bisnis/proyek yang bersangkutan.

Tulisan Prof. A. Damodaran tersebut secara khusus mengingatkan pentingnya analis untuk kembali ke focus Arus Kas. Tulisan tersebut disajikan dengan memberikan data-data terkini untuk awal tahun 2017 terkait valuasi dan cost of capital, termasuk tingkat imbal hasil historis, implied equity risk premiums, premi resiko negara.

Prof. A. Damodaran dalam kesimpulannya terkait Cost of Capital menyebutkan dalam

When your valuations go awry, it is almost never because of the mistakes that you made on the discount rate and almost always because of errors in your estimates of cash flows (with growth, margins and reinvestment)

Tiga key driver yang disebutkan yaitu growth, margins dan reinvestment, adalah yang penting untuk difokuskan untuk memastikan sejauh mungkin bisa diperoleh proyeksi arus kas yang “akurat”, dan telah menggambarkan atau mencakup seluruh resiko bisnis yang ada. Dengan demikian, analis diharapkan justru tidak terlalu terobsesi dengan hal-hal kecil terkait Discount Rate.

Yang menarik, bahkan Prof. A. Damodaran memberikan tip untuk penentuan Cost of Capital apabila analis tidak memiliki banyak waktu, yaitu untuk valuasi perusahaan dengan tingkat resiko rata-rata, maka Cost of Capital sebesar 8% dapat dipertimbangkan untuk digunakan, atau kalau masuk dalam kategori bisnis yang sangat beresiko, maka 10,68% dapat digunakan sebagai dasar.

“An approximation works well : When I am in a hurry to value a company, I use my distributional statistics (see graph above) to get started. Thus, if I am valuing an average risk company in US dollars, I will start off using an 8% cost of capital (the global median is 8.03%) and complete my valuation with that number, and if I still have time, I will come back and tweak the cost of capital. If it is very risky firm, I will start off with a 10.68% cost of capital (the 90th percentile) and gain revisit that number, if I have the time.”

Sebagai penutup tulisan, Prof. A. Damodaran menyebutkan:

All in all, if your find yourself obsessing about the minutiae of discount rates in a valuation, it is perhaps because you want to avoid the big questions that make valuation interesting and challenging at the same time.”

Berk dan DeMarzo dari Stanford University menyampaikan nada yang sama dengan Prof. A. Damodaran di atas. Dalam buku teks Corporate Finance, dikutip bahwa

“Given the evidence for and against the efficiency of the market portfolio, what method do managers actually use to calculate the cost of capital? A survey of 392 CFOs conducted by John Graham and Campbell Harvey found that 73.5% of the firms that they questioned use the CAPM to calculate the cost of capital, as indicated in Figure 13.11. They also found that larger firms were more likely to use the CAPM than were smaller firms.”



“In short, there is no clear answer to the question of which technique is used to measure risk in practice—it very much depends on the organization and the sector. It is not difficult to see why there is so little consensus in practice about which technique to use. All the techniques we covered are imprecise. Financial economics has not yet reached the point where we can provide a theory of expected returns that gives a precise estimate of the cost of capital. Consider, too, that all techniques are not equally simple to implement. Because the trade-off between simplicity and precision varies across sectors, practitioners apply the techniques that best suit their particular circumstances.”


“When making a capital budgeting decision, the cost of capital is just one of several imprecise estimates that go into the NPV calculation. Indeed, in many cases, the imprecision in the cost of capital estimate is less important than the imprecision in the estimate of future cash flows. Often the least complicated models to implement are used most often. In this regard, the CAPM has the dual virtues of being both simple to implement and reasonably reliable.

Dikutip dari Jonathan Berk dan Peter DeMarzo. Corporate Finance. Edisi ketiga. MA (USA): Pearson Education, Inc. 2014. Bab 13 : Investor Behavior and Capital Market Efficiency. Halaman 466.

Menarik juga dikutip dari buku teks klasik Principles of Corporate Finance oleh Brealey dan Myers:

Profits that more than cover the opportunity cost of capital are known as economic rents. These rents may be either temporary (in the case of an industry that is not in long-run equilibrium) or persistent (in the case of a firm with some degree of monopoly or market power). The NPV of an investment is simply the discounted value of the economic rents that it will produce. Therefore when you are presented with a project that appears to have a positive NPV, don’t just accept the calculations at face value. They may reflect simple estimation errors in forecasting cash flows. Probe behind the cash-flow estimates [catatan penulis: tidak disebutkan untuk mengecek Cost of Capital atau Discount Rate yang digunakan dalam analisa tersebut, tapi pada key drivers di belakang pembentukan estimasi arus kas], and try to identify the source of economic rents. A positive NPV for a new project is believable only if you believe that your company has some special advantage.”

Dikutip dari Principles of Corporate Finance. Richard A. Brealey dan Stewart C. Myers. Edisi keenam. USA: The McGraw-Hill Companies, Inc. 2000. Bab 11: Where Positive Net Present Values Come From. Halaman 297.

Respons dari Ignacio Velez-Pareja (Jan/Feb 2017)

100% agree!

That is why we care very much about the detailed financial model. Remember that my financial model captures investments and debt when needed. Once you have that model, the CF is crystal clear (because it comes from what I call the Cash Budget). 

This part of the work is the most time consuming. Remember as well, that Cost of [financing] Capital (CofC) basically depends on one or two numbers: beta and equity risk premium. CFs depends on MANY input variables.

And finally, you end up sensitivizing ALL variables, including of course, beta and ERP!

This doesn’t mean that we consider CofC secondary, nevertheless. The issue is that many scholars devote LOT of time and effort to define with complex econometric models what beta and ERP should be and pay much less attention to the CFs. More, many still use the idea of plugs to check and match forecasted financial statements from where you derive CFs! This makes no sense at all.

Karnen’s view:

We need to see whether the horizon is short-term or long-term. In long-term, CFs error is critical as interest rate historically quite in predictable range, we have 10-yr government bond being traded in market. Something similar for CFs that we can’t find. Most of valuation didn’t happen not because of discount rate, but the CF doesn’t show up in the first place. Discount rate is just needed because we apply time value of money and compare more than 1 project with different pattern of cash flows being generated.

I give here a very simplified example of the impact of the error we made for cash flow forecast vs discount rate/cost of capital both for short-term and long-term projects.


Short-term projects: Assuming a generated cash flow of IDR 100 mio next year with the discount rate of 10%.

10% cash flow estimation error: cash flow put as IDR 110mio next year

10% discount rate estimation error: discount rate used at 11%


 PV correct = 100/10% = IDR 1,000

PV cf error (10%) = 110/10% = IDR 1,100 (=10% error from PV correct above)

PV dr error (10%) = 100/11% = IDR 909 (=9% error from PV correct above)

In this simplified short-term project, the error made in CF yields bigger impact to the PV).

Long-term projects: assuming the cash flow to be generated in 25 years, instead, next year.

PV correct = 100/[(1+10%)^25] = IDR 9.2

PV cf error (10%) = 110/[(1+10%)^25] = IDR 10.2 (=10.00% error from PV correct above)

PV dr error (10%) = 100/[(1+11%)^25] = IDR 13.6 (=20.25% error from PV correct above)

From the simplified long-term project example, the error being made from discount rate has much bigger impact to the PV, compared to that 10% estimate error on the cash flow.

Will this mean that for the long-term projects, estimating correct discount rate is more important than getting the a better estimation of cash flow forecast?

Not really, this could mislead us, since we are talking two things of estimation that are not apple-to-apple to compare.

Estimating cash flows into the next 25 years are quite challenging, and I could say 100%, we will totally be like a fortune-teller than a person coming out from valuation course. The uncertainty will be extremely high over longer horizons. On the other side, the uncertainty in estimating the cost of capital in the long-term tends be “predictable” in the sense, we could use 5-year, 10-year, 30-year bonds as a starting point to look at. Historically, the interest rate range is not that wide enough to make it too hard to predict that in the long-term.

Other thing error is not about what we put there in cash flow forecasting but the execution issue. Meaning forecasting error might not be the issue.

Ignacio Velez-Pareja’s response:

You are right. However, this is the most common approach to valuation: a point use of the tool. No. As you say, management is something dynamic. You should not use the tool to get a magical number and close a deal. My idea is that the valuation tool, the financial model, should be used permanently as a management tool to keep value in line with the goal. 

The market is full of Value Management courses, seminars and workshops. However, they do that is on the thin air. How could you manage value without knowing it? The financial model to value the firm today should be used PERMANENTLY as a management tool to track and keep value in line with the goal! Follow?

It is crazy to think that forecasts will be achieved without the hand of management. It is a permanent fight between reality and plans. Of course that reality will deviate from plans and the manager should have the tools to CORRECT what reality makes on our plans. And here the financial model is the clue. Reality changed my plans and the calculated value. What should I do in order to “recover” the value lost this month or this year? How much should I change my strategies and which of them to keep value on track?

What I teach is that valuation should not be used to know the value today, close a deal and forget what is in the valuation model. It should be considered a management tool to manage by value! That is the clue of all this we do on valuation. It is beyond determining a value at a point in time. It is a dynamic process and the financial value model is the proper tool to manage Value.

This makes a lot of difference.

Back to Prof. A. Damodaran’s blog, I agree that we need to keep an open mind when we are building the projected cash flow and discount rate, and be aware of that the error behind cash flow might play a bigger role in yielding “veered so far from the mean”.

5 February 2017