Hi all,

I have a few questions about NPV and DCF:

1- Where would you use one or the other? Investment cases / Valuation cases

2- When you use ROI in lets say an investment case, would you use the result of DCF, NPV, or neither?

Thanks a lot

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# How to use DCF, NPV and ROI

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Hi all,

I have a few questions about NPV and DCF:

1- Where would you use one or the other? Investment cases / Valuation cases

2- When you use ROI in lets say an investment case, would you use the result of DCF, NPV, or neither?

Thanks a lot

2 Answers

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NPV= Net Present Value- [-investment +( Summation of FCF/(1+wacc)^t from 1 to t)].This is a basic formula, it is way more involved than the substituting numbers in the formula, typical you would need to create a DCF model based on a pro forma to get the FCF and terminal value. We could spend hours discussing adjustments, discount rate calculation (WAAC or APV), growth rates, and terminal valve assumptions etc. but for a case situation, the intuition and application of the formula rather than the development of the model would be required.

In short, NPV of a deal is today's value of all future streaming of free cash flow generated from the deal in question. If it’s above 0 or positive then you should do the project, if below 0 or negative, then you shouldn't do the project.

So all you need in essences is FCF and the Discount rate or WACC and the time horizon to evaluate.

P.S- Clarify with the interview the approach and formula you plan to use, as well as the assumptions.

On the other hand, ROI is simply (N.I/Investment) this doesn't take discount rate or WACC into account, which makes it inferior to NPV, You could call ROI a payback estimator (inverse of ROI= Payback) that doesn't take risk, inflation and opportunity cost into account. ROI is a quick and dirty estimate to sniff test the deal.

For instance, If payback time requested by your client is 2 years and your ROI/payback analysis yields 20% or 5years then you can almost be certain its not a +NPV project and should be cautious about making the deal, else other strategic reasons support doing so. For example, accepting the deal because it’s serves as a structural barrier to deter entry by competition etc.

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Valuation

This type of case can either be a subset of an M&A case, in which you need to know a company's worth before purchasing, or a standalone case (rare). For instance, “How much is Pfizer worth today?” In strategy consulting, these questions are rather rarely seen. However, cases where you do need to value something usually start with “How much would you pay for company XY?” The Most Common Methods of Valuing Are the Discounted Cash Flow (DCF) and the Industry Multiple MethodAs these are still case studies meant to fit in an interview round, the interviewer will very likely not ask you to perform an exact and comprehensive valuation analysis. Instead, you may be required to estimate the worth of a product, patent, or a service. You may also have to judge if an offered price is reasonable. Discounted Cash Flow methodThe first valuation method is the Discounted Cash Flow method. This method shows how much money you would have in your savings account at a certain interest rate in order to provide you with the same annual cash flow generated by the company that is being evaluated.Here, you simply divide projected annual cash flows by a discounted rate (or interest rate). Of course, the discount rate of your savings account will be much lower than that of an investment in a company. This is so because the risk you take putting your money in a savings account is much lower than the risk of investing in a company.👉 For more details on how to use the Discounted Cash Flow (DCF) method, have a look at our Net Present Value (NPV) lesson Industry Multiple MethodThe DCF method is limited since it does not take into account additional dimensions other than money (unless you quantify those dimensions into the future cash flows).Football teams, for instance, are often overvalued compared to their generated returns. For such cases, there is another method called the industry multiple method.This method allows you to value a firm by using a metric known of this company and multiplying it by the associated industry multiple. This can be done for similar players in the industry to assess their relative valuations using benchmarking.An example of a multiple ratio is the price-to-book ratio (P/B). This multiple is the ratio of the actual firm valuation (based for example on M&A deals) and the book value of the same firm (value of its assets, which can be found in the balance sheet). If a firm’s assets added up to 200 million, and it was sold for 100 million, the ratio is 0.5 (100 million/200 million).Do this for a set of representative industry players, take the average and you get the average industry multiple. Finally, you multiply the industry multiple with the value of the assets.Other commonly used ratios are the price-earnings ratio (P/E ratio or PER) and the EBITDA ratio.Since you will not be required to calculate the value of an investment on too high a level of detail, it is not necessary to learn values for different interest rates or industry multiples by heart. However, to give you an idea about orders of magnitude:A good guess for an industry multiple is EBITDA*10.Good guesses for interest rates would range from 3% (inflation) to up to 20% for highly speculative investments. Key takeawaysUse the Discounted Cash Flow (DCF) method to value a firm based solely on its expected profits.Use the industry multiple method to double-check if the DCF valuation is reasonable. Sometimes other aspects need to be factored in like brand value, customer loyalty, liabilities, etc.There are several types of industry multiples to choose from. For more precise valuation, choose more types of industry multiples. Practice M&A cases to optimize your valuation-techniques:👉 tkMC Case: Portfolio optimization of a holding company👉 Bain Case: Old Winery

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