The Daily Technical #60: When calculating enterprise value, why do we add net debt?

Good morning. Welcome to the 60th edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
Contrast the discounted cash flow (DCF) approach to the trading comps approach.

Advantages

Discounted Cash Flow (DCF): The DCF values a company based on the company’s forecasted cash flows. This approach is viewed as the most direct and academically rigorous way to measure value. Considered to be independent of the market and instead based on the fundamentals of the company

Trading Comps: Trading comps value a company by looking at how the market values similar businesses. Thus, comps relies much more heavily on market pricing to determine the value of a company (i.e., the most recent, actual prices paid in the public markets). In reality, there are very few truly comparable companies, so in effect, it's always an “apples and oranges” comparison.

Disadvantages 

Discounted Cash Flow (DCF): The DCF suffers from several drawbacks; most notably, it's very sensitive to assumptions. Forecasting the financial performance of a company is challenging, especially if the forecast period is extended. Many criticize the use of beta in the calculation of WACC, as well as how the terminal value comprises around threequarters of the implied valuation.

Trading Comps: While the value derived from a comps analysis is viewed by many as a more realistic assessment of how a company could expect to be priced, it's vulnerable to how the market is not always right. Therefore, a comps analysis is simply pricing, as opposed to a valuation based on the company’s fundamentals. Comps make just as many assumptions as a DCF, but they are made implicitly (as opposed to being explicitly chosen assumptions like in a DCF).

Common Mistakes

1. Not recognizing how assumptions impact the DCF model's outcome. Emphasize the importance of accurate forecasting and understand that small changes in assumptions can lead to large variances in results.

2. Mistakenly thinking that trading comps are purely objective. Trading comps are influenced by current market conditions, which can be irrational or volatile.

3. Assuming that comparable companies are easy to find. Each business has unique characteristics, making perfect comparisons rare.

TL;DR

• DCFs focus on forecasted cash flows and fundamentals, offering an independent and academically rigorous valuation but they are highly sensitive to assumptions, with challenges in long-term forecasting; terminal value often skews results.

• Comps value companies based on market pricing of similar businesses, providing real-time insights but they rely on market conditions and implicit assumptions, which may not align with intrinsic value.

• DCF is a fundamentals-based valuation; Comps depend on market-based pricing. Each has its respective strengths and weaknesses.

TODAY’S QUESTION
When calculating enterprise value, why do we add net debt?

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THAT’S A WRAP
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