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Discounted cash flow is a widely used method for valuing companies. It is based fundamentally on the sum net present value of the future free cash flows.

The free cash flow is based on the EBITDA with some adjustments.

My question now is this: Why is it ok to ignore D&A in the valuation? I realize that those are not cash-effective, but they are “technical insolvency-effective”.

I.e. if the D&A are too large over a long term, the company may consistently show negative earnings that when carried forward may exceed its equity. Is this not the textbook definition of a technical bankruptcy? So while the company may stay liquid enough to service its loans, it may still be forced into insolvency — which would seem to impair its ability to repay its loans.

If so, how can this be irrelevant to company valuation?

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There are thousands of methods to valuate a company, each has a different perspective. While in Europe most valuation methods focus on earnings, especially in North America cash-flow related methods prevail.

What is depreciation? Depreciation itself is an approach to to harmonize the profit/loss account and show a fair value of the asset itself. Without depreciation, investments would have a huge impact to the balance sheet of a company and veil the true fair value of its assets.

Why is depreciation no part of the cash flow calculation? If you purchase an asset like a car or property, you have a negative cash-flow of the assets purchase price (you pay your bill). The cash is no part of your company anymore. You now have the property with a book value of X. If your property gets depreciated, does it impact your cash? Do you have to pay for it? No, it has no impact on your bank account! If your property's book value increased, does it impact your cash? Do you get any more for it? No, there is also no impact to your bank account!

"Why is it okay to ignore D&A's in the valuation?" As mentioned in the first statement, the cash-flow valuation approach is just one approach to value a company and there are many perspectives. The DCF-approach does not claim to be completely comprehensive (which is impossible to achieve). As the rules for companies creating a DCF-analysis are exactly the same, this allows stakeholders to compare the company with other companies.

"I realize that those are not cash-effective, but they are “technical insolvency-effective" Are they? There is no thing as insolvency in DCF. DCF is not used to measure the risk of insolvency. On the other hand (assuming that all assets get paid in the year they get purchased), the value of an asset is higher in the balance sheet than in the cash-flow statement.

Lets assume you buy a car for 14,000 and depreciate it linear over 7 years. This means that in the year of purchase your cash-flow is -14,000, while your earnings are only -2,000. The cash will never change in the following years, but the book value is reduced by 2,000. After 7 years, your total cash-flow and earnings will be even.

"if the D&A are too large over a long term, the company may consistently show negative earnings that when carried forward may exceed its equity."

See the example above, the earnings of fixed assets are always higher than the cash-flow, so the scenario just does not exist. In this certain area, DCF is a way more conservative approach than most income-statement based approaches (Which is paradox because DCF became popular because most income-statement based approaches appeared to be too conservative and to overprice risks).

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Why is it ok to ignore D&A in the valuation?

In theory, D&A will be accounted for in the "terminal value" of assets. You can't just depreciate an asset forever or arbitrarily - you have to assign a practical life and a "salvage value". When a company depreciates an asset, it assigned a salvage value that it thinks the asset will be worth over it's depreciable life. If the company disposes of that asset for its salvage value, that's when the depreciation is taken into account. It's also common for these assets to be refurbished or replaced, which is accounted for in the "investing" section of the cash flow statement. From a cash flow standpoint, the change in cash spent is discounted from that point.

if the D&A are too large over a long term, the company may consistently show negative earnings that when carried forward may exceed its equity. Is this not the textbook definition of a technical bankruptcy?

No - a bankruptcy is when a company is not able to pay its debts. Just having more debts than assets is not "bankrupt". A company can have more debts than assets and still be able to make its debt payments. It's certainly a big red flag, and warrants further scrutiny, but it does not always mean that a company is bankrupt.

DCF is just one way of measuring an entity's value. It certainly has its drawbacks, but so does pure earnings analysis.

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  • Not forgetting that the asset has already been paid for, which at the time affected the cash flow, thus has already been accounted for. Scrap value of the asset does mean something, but is probably minuscule in the terminal value.
    – ssn
    Jul 31 '20 at 19:39
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I don't think DCF, at least the correct ones, ignore D&A. D&A is required when calculating Free Cash Flow. You can check out this DCF of Google.

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  • Are you affiliated with valueinvesting.io?
    – Flux
    Oct 2 at 1:30
  • D&A is a non-cash expense so it is not used in DCF. If you calculate cash flow by starting with net income (which includes D&A, then you must back it out. So it's "required" only if you start with an amount that includes it already.
    – D Stanley
    Oct 2 at 16:34

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