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Based on interviews with major investment hanks, we report how these leading practitioners apply discounted cash flow (DCF) techniques to value business enterprises. We find considerable alignment among the advisors and between practice and academic advice on major themes, including assessments of risk informed by data from financial markets and on the use of comparable company data. Our conversations reveal a complex set of judgments on valuation. While leading practitioners routinely use DCF methods in mergers and acquisitions (M&A) valuations, the application is often far from "routine it requires art and judgment in the face of inherently uncertain business forecasts such as those surrounding merger synergies. Our results serve as yet another reminder that analytic techniques such as DCF do not make decisions but only inform them.
*Each year firms spend billions of dollars on mergers and acquisitions. Over the last decade alone, US merger and acquisition (M&A) volume exceeded $12 trillion.1 In each transaction, both buyer and seller had to value a business and conclude that the terms of the deal were favorable to their interests. Given the complexity of business valuation, it is no surprise that practicing managers encounter a myriad of challenges when estimating a firm's value in an M&A transaction. The primary academic recommendation is to value a firm using discounted cash flow (DCF), the same method used for evaluating projects and informing capital budgeting. The DCF framework applies a flexible tool to model key business assumptions about profitability, asset requirements, growth and risk. In practice, an array of valuation approaches is used including DCF, multiples of public companies and multiples of recent transactions.2
This paper reports on if, and how, leading practitioners from major investment banks use DCF techniques to value businesses. We focus on these practitioners because they are continually involved as financial advisors in acquisitions, they represent both sellers and buyers, and they cover a large proportion of M&A activity.3 Based on interviews with these top investment banks, we find that there is considerable alignment among financial advisors and between practice and academic advice on several key topics. Across our sample we found the following:
* All used DCF as a method to estimate the enterprise value of a company.
* All based their discount rates...