Investors warned to watch valuation approaches

The discounted-cash-flow approach should not be far apart from the public-market comparable approach, argues Duffs & Phelps valuation expert PJ Viscio. General partners should avoid the temptation to 'split the difference' when different valuation methods produce different results.

PJ Viscio

As the year-end valuation season approaches, one expert is warning that two different valuation methods should not produce widely different results when applied to the same investment.

PJ Viscio, a managing director at Duff & Phelps, wrote in the December issue of PEI Manager that a warning flag should go up when a discounted-cash-flow (DCF) approach to valuation produces a very different result than a public-market comparable approach.

Viscio said that since private equity investors rely on  “observed multiples in the market place”, investments should be priced on a going-forward basis benchmarked to multiples observed in the market.

However, Viscio said that “one may even think of a multiple approach as a shortcut DCF”.

“Market multiples can be thought of as benchmarks of risk and return,” Viscio said. “Within a comparable group (where there is comparable business risk), the key driver of the resulting multiple is expected growth, also a key driver of value indicated by a DCF.”

When the results of a DCF and a multiple approach differ significantly, it indicates that the underlying assumptions, explicit or implicit, used in the two analyses are inconsistent with each other. A higher DCF value could be the result of overly aggressive growth rate assumptions. Or the disparity might be the result of a problem with the comparable companies used.

GPs should avoid the temptation to simply “split the difference” when different valuation methods yield different results, he said.

“It would be like having two watches where one reads noon and the other reads 6 pm, and then concluding that the time is actually 3 pm,” he said. “This means that at least one watch has the wrong time and the 3 pm estimate is not particularly meaningful.”

Valuation is one of the main topics covered in the December issue of PEI Manager