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.
Formulas
Constant-growth cash flow value
V = F₁ ÷ (r − g)
- V
- the value today
- F₁
- the free cash flow expected next year
- r
- the required return
- g
- the steady long-run growth rate
Two analysts with the same model reach different values by choosing different r and g, and the gap is very sensitive to them.
A practice question
Holding revenue and margins constant, an analyst who assumes higher capital expenditure will estimate a company's value to be:
- higherWhy not: Treats capex as adding value directly; with no extra revenue, it only reduces free cash flow.
- lower - correct
- unchangedWhy not: Overlooks that free cash flow is after investment, so higher capex reduces the cash available.
Free cash flow = operating cash flow − investment. More investment with no extra revenue or margin reduces cash flow and value.
A harder one
Two analysts forecast revenue of 2,000 for Iveson Glass. A assumes a 10% EBIT margin, B a 12% margin. With no debt, a 25% tax rate, a P/E of 14 and 100 shares, how much higher is B's value per share?
- 4.20 - correct
- 5.60Why not: Applies the P/E to the pre-tax EBIT difference, ignoring the 25% tax on the extra profit.
- 0.30Why not: Stops at the difference in EPS and does not multiply by the P/E to convert it into value.
EBIT difference = 2,000 × 2% = 40; after tax = 30; per share = 0.30; value difference = 0.30 × 14 = 4.20.
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.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →