Tuesday, February 28, 2006

DCF Models

Good and snarky post re deal making on a new private equity focused blog, “Going Private.” I like the explanation for modeling discounted cash flow, which I believe is still the gold standard for valuing any operating business. Comps are interesting, but really just as a point of reference or sanity check. I’m fortunate in never having had to construct a DCF model, but I’ve spent enough time pulling apart and tweaking them (or, more accurately, standing over my analyst’s shoulder and saying things like: “What if we assume we lose two-thirds of the customers we acquire when we force them to change rate plans?”) to know how useful they are in analyzing how an acquired business can fit into its new corporate collective. But there are two important rules corporate development types need to keep in mind when developing DCF models:

1. The model must mirror the inputs in your company’s long-term planning model, no matter how ridiculous.
2. Any deviations from rule #1 must be very strongly supported. Rest assured that your CFO will run your model by the planning trolls, and you will be asked to explain all major differences.

Any acquisition will have deviations, particularly in the first couple of years, and they are easy to explain if you are prepared. Just don’t get put in a position where you have to explain why your proposed acquisition is supposed to be generating margins 500 bp higher than the core business 8 years post-integration.

Anyway, I’m sure at some point the anonymous author of Going Private will want to own up – there’s some good (and funny) writing there. I particularly like this brutal assessment of Guy Kawasaki’s blog – ouch!

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