The basic equation for DCF is as follows:
Each of the above mentioned components hold significant contribution in deriving the intrinsic value of the company. Each component is described below.
Free Cash Flow (FCF)
Free cash flow is the cash available with the company after all the expenses incurred. It is the cash that is left from its operational activities and can be used to pursue opportunities to enhance the wealth of shareholders.
We need to forecast revenues in future to calculate free cash flow (FCF) considering the company’s future prospects. Once we have the forecasted revenues, we find out the Free Cash Flow.
Free Cash Flow is further sub divided into two categories:
Free Cash Flow to Firm (FCFF): It is the cash flow available to the providers of capital after all operating expenses, taxes, working capital and capital investments are made.
FCFF=EBIT-Taxes+Depreciation(non cash cost)-Capital spending-Increase in working capital
Free Cash Flow to Equity (FCFE): It is the cash flow available to the equity owners, calculated by subtracting taxes, reinvestment needs and debt cash flow.
FCFF=EBIT-Interest-Taxes+Depreciation(non cash cost)-Capital spending-Increase in working capital+New Debt Issues
The terminal value is the Value of the company beyond the forecast period. To forecast the long term future cash flows after the projection period is practically not possible. Therefore we calculate the terminal value under the going concern assumption using two methodologies mentioned below:
Gordon Growth Perpetuity Model: It is the growing perpetuity method and assumes that business will continue to grow and earn more than its cost. Nominal GDP growth rate of the country can be taken as a proxy for sustainable growth rate.
Exit Multiple: This approach is applied when the business is valued on market multiple basis. Usually, value is determined based on EBIT or EBITDA multiples. A normalized multiple is used which is the industry multiple adjusted for cyclical variations.
It is always very important to calculate the implied perpetuity growth and exit multiples by cross linking each other. They both should be in a reasonable comfort zone.
The discount rate is the return expected by the different classes of capital providers like debt and equity, which is used to discount the forecasted cash flows to derive the present intrinsic value.
Discount rate to be used depends upon whether to value Equity or the Firm.
• To value equity, equity cost is used to discount the cash flow available to equity shareholders. Dividend discount model is a special case of equity valuation.
• To value firm, WACC is used, which is the weighted average of the cost of equity and the cost of debt based on the proportion of debt and equity in the company’s capital structure of the company. However it must reflect the long-term targeted capital structure as opposed to the current capital structure.
While estimating WACC, one should consider the following points:
• Avoid mismatching cash flows and discount rates.
• WACC must use nominal rates of return to discount nominal cash flows because the expected cash flows are expressed in nominal terms.
• Market value weights must be used to reflect the true economic value of the investment made.
• In situations where projections seem to be aggressive, it may be appropriate to use the higher discount rate than if it would have been normal.
To conclude, as it is quite evident that DCF is a very powerful tool to determine the intrinsic value of the company, however the accuracy of the value determined is highly dependent on the quality of the inputs used. Therefore DCF should be used only when there is a high degree of confidence to forecast cash flows otherwise a small change in a component could lead to big change in the intrinsic value.