Explain how analysts working from one model can still arrive at different values
The idea
Two analysts can use the same model and reach very different values because the model is only a framework: the answer comes from the inputs. Differences in revenue growth, margins, the investment needed to support growth, financing and the required return compound over a long forecast period and the terminal value. A small change in long-run growth or the discount rate can move a DCF value substantially. Judgements about which scenario is most likely, what counts as a one-off item, and how long a competitive advantage lasts all differ. This is why a credible valuation states its key assumptions, shows sensitivity to them and explains why its view differs from the market price.
A practice question
Two analysts use the same discounted cash flow model for a company but reach different values. The most likely reason is that they:
- use different accounting standardsWhy not: The model and the company's reported accounts are the same; the forecasts are what differ.
- apply different formulas for valueWhy not: Using the same model means applying the same formula, so that cannot explain the gap.
- use different input assumptions — correct
Differing forecasts of revenue, margins, investment and financing, and different discount rates, produce different values from the same model.
A harder one
Analyst A expects Thorne Cables' FCFE next year of 5.00 per share, a required return of 10% and constant growth of 4%. Analyst B agrees except that growth is 5%. Analyst B's value per share is:
- 100.00 — correct
- 105.00Why not: Grows next year's FCFE a second time before dividing, when 5.00 is already the forward figure.
- 33.33Why not: Divides by the required return plus growth rather than the required return minus growth.
B's value = 5.00 / (0.10 − 0.05) = 100.00, compared with A's 5.00 / (0.10 − 0.04) = 83.33. One point of growth changes the value by 20%.
The hardest tier
Selwick Engines will have EBIT of 160, a 25% tax rate and 100 shares. It needs 200 of funding. Analyst A assumes 10 new shares are issued; analyst B assumes debt at 6%. B's forecast EPS is:
- 1.08Why not: Deducts interest after tax has been applied, losing the tax deductibility of interest expense.
- 1.20Why not: Ignores the interest cost on the new debt, treating the funding as free.
- 1.11 — correct
B: interest = 0.06 × 200 = 12; net income = (160 − 12) × 0.75 = 111; EPS = 111 / 100 = 1.11. A: 120 / 110 = 1.09. Financing assumptions alone change EPS.
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