24 Nov 2010Working Paper Summaries

Valuation When Cash Flow Forecasts Are Biased

by Richard S. Ruback

The valuation of forecasted cash flows can be an inaccurate process, especially when the forecasts are created by optimists who neglect to consider worst-case scenarios. In this paper, Harvard Business School professor Richard S. Ruback has developed methods of valuating forecasted cash flow when the predictions are biased upward. Key concepts include:

Managers often recognize that their cash flow forecasts are too optimistic and boost their discount rates to account for that bias. But that only works if the optimism masks a potential permanent downside.
The common practice of increasing the discount rate to account for optimistic cash flow forecasts can lead to significant valuation errors that increase with the length of the project, the cost of the capital, and the chance of a downside.
When the optimistic cash flow forecasts omit a temporary downside, valuators should adjust the forecast by deflating it and then setting the discount rate equal to the cost of the capital. In other words, the common heuristic of boosting the discount rate to account for optimistic cash flow can lead to a substantial valuation error when the omitted downside isn't permanent.
When the optimistic cash flow forecasts omit a potential permanent downside so that, if it occurs, there is no chance of recovery, valuators should deflate the cash flow forecast and increase the discount rate so that it includes the cost of capital as well as the probability of a downside.

Author Abstract

This paper focuses adaptations to the discount cash flow (DCF) method when valuing forecasted cash flows that are biased measures of expected cash flows. I imagine a simple setting where the expected cash flows equal the forecasted cash flows plus an omitted downside. When the omitted downside is temporary, the adjustment is to deflate the forecasts and to set the discount rate equal to the cost of capital. However, when the downside is permanent, the adjustment is to deflate the cash flows and to increase the discount rate so that it includes the cost of capital plus the probability of a downside.