The discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth. The concept of DCF valuation is based on the principle that the value of a business or asset is inherently based on its ability to generate cash flows for the providers of capital. To that extent, the DCF relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach relying on numerous assumptions. A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity.
Free cash flow (FCF) – Cash generated by the assets of the business (tangible and intangible) available for distribution to all providers of capital. FCF is often referred to as unlevered free cash flow, as it represents cash flow available to all providers of capital and is not affected by the capital structure of the business.
Terminal value (TV) – Value at the end of the FCF projection period (horizon period).
Discount rate – The rate used to discount projected FCFs and terminal value to their present values.
DCF Methodology
The DCF method of valuation involves projecting FCF over the horizon period, calculating the terminal value at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to arrive at the NPV of the total expected cash flows of the business or asset.
Exhibit A – Advantages and Disadvantages
Advantages
Disadvantages
Theoretically, the DCF is arguably the most sound method of valuation.
The DCF method is forward-looking and depends more on future expectations rather than historical results.
The DCF method is more inward-looking, relying on the fundamental expectations of the business or asset, and is influenced to a lesser extent by volatile external factors.
The DCF analysis is focused on cash flow generation and is less affected by accounting practices and assumptions.
The DCF method allows expected (and different) operating strategies to be factored into the valuation.
The DCF analysis also allows different components of a business or synergies to be valued separately.
The accuracy of the valuation determined using the DCF method is highly dependent on the quality of the assumptions regarding FCF, TV, and discount rates. As a result, DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs. It is also common to run the DCF analysis for different scenarios, such as a base case, an optimistic case, and a pessimistic case, to gauge the sensitivity of the valuation to various operating assumptions. While the inputs come from a variety of sources, they must be viewed objectively in the aggregate before finalizing the DCF valuation.
The TV often represents a large percentage of the total DCF valuation. Valuation, in such cases, is largely dependent on TV assumptions rather than operating assumptions for the business or the asset.
Steps in the DCF Analysis
The following steps are required to arrive at a DCF valuation:
Project unlevered FCFs (UFCFs)
Choose a discount rate
Calculate the TV
Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present value
Calculate the equity value by subtracting net debt from EV
Review the results
Exhibit B – DCF Template
The following spreadsheet shows a concise way to build a “best-practices” DCF model. Calculation of unlevered cash flow may be modified as warranted by your specific situation. Each of the steps required to conduct a DCF analysis is described in more detail in the following sections. You can download the DCF template below.
Note that while unlevered free cash flow inputs are hard-coded in blue here, they would normally be linked to income and cash flow statement items in practice.
Discounted cash flow analysis finds the present value of expected future cash flows using a discount rate. Investors can use the present value of money to determine whether the future cash flows of an investment or project are greater than the value of the initial investment.
The discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth.
The discounted cash flow (DCF) formula is equal to the sum of the cash flow in each period divided by one plus the discount rate (WACC) raised to the power of the period number.
The DCF is often compared with the initial investment. If the DCF is greater than the present cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash.
As such, a DCF analysis can be useful in any situation where a person is paying money in the present with expectations of receiving more money in the future. For example, assuming a 5% annual interest rate, $1 in a savings account will be worth $1.05 in a year.
Discounted cash flow (DCF) refers to valuation techniques that estimate the value of an investment based on predicted future cash flows. DCF analysis seeks to determine an investment's value today based on a forecast of how much money it will generate in the future.
How to Value Stocks Using DCF? Valuing stocks using DCF is pretty much the same method when valuing a company but you just take one extra step. Once you have added all your future discounted cash flows together, you get the value of the business today.Then you simply divide this figure by the number of shares.
IRR is a metric that represents an estimated discount rate that would return a net present value of zero when performing a discounted cash flow (DCF) analysis. Simply put, it is the rate of return required for an investment's present value of cost to equal its present value of future cash flows.
The dollar you have in your wallet today has more buying power than a dollar a year from now. That's because of different factors, like the effect of rising inflation. The time value of money is the reason why you discount cash flows.
The choice between DCF and EBITDA Multiple depends on variables such as industry, company stage, and access to financial information. While DCF is preferable for companies with stable cash flows over time, the EBITDA Multiple is more suitable for rapidly evolving sectors or those with a complex financial structure.
Introduction: My name is Geoffrey Lueilwitz, I am a zealous, encouraging, sparkling, enchanting, graceful, faithful, nice person who loves writing and wants to share my knowledge and understanding with you.
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