Discounted Cash Flow analysis (DCF) is a process wherein we calculate the value of an organization or an asset by using the concept of Time Value of Money, that is, what price should be paid today to have an investment at a certain amount of money at a future date. In this method, all the future cash flows are discounted to arrive at their present values by using cost of capital.
The time value of money is based on the assumption that a dollar today is worth more than a dollar tomorrow and the reasons for this assumption can be – Uncertainty to receive the money in future, inflation in future and opportunity cost i.e. money could have been invested elsewhere.
Key Components of Discounted Cash Flow Analysis
Free Cash Flow (FCF) – It can be defined as a true measure to understand the amount of cash flows that are available to shareholders and to the creditors. In other words, it calculates how much money is left with the company to pay the debts, investors etc.
Also Read: COMPONENTS OF DISCOUNTED CASH FLOW ANALYSIS
FCF = EBIT (1-t) + Depreciation & Amortization – Capital Expenditure +/– Change in Working Capital
EBIT = Earnings before interest and Tax
t= Corporate Tax rate
Terminal Value (TV) – It is the value of an investment which is left at the end of a specific time period. It is the value at the end of the FCF projection period.
There are two approaches for calculating Terminal Value:
Perpetual Growth Method (Gordon Growth Model)
This method assumes that the business will continue till perpetuity and will generate Free Cash Flows at a stable rate.
TV = [FCF*(1+g)] / (WACC – g)
TV = Terminal Value
FCF = Free Cash Flow
G = Perpetual Growth rate of FCF
WACC = Weighted Average Cost of Capital (Discount Rate)
Exit Multiple Method
This method assumes that market multiple is an appropriate way to value a Business. A value is typically determined as a multiple of EBIT or EBITDA.
TV = Financial Metric (EBITDA) * Trading Multiple
Points to be noted here are:
- The multiple should be calculated by valuing the comparable companies.
- Multiples should be normalized.
- The multiple calculated should reflect long term market valuation of the company instead of the current multiple which can easily be altered by the industry.
Discount Rate (Weighted Average Cost of Capital)
The Rate which is used to discount the projected FCFs and the Terminal Value to their present values is the Discount Rate.
In order to calculate WACC, we need the Cost of Equity which is the % of equity in the capital structure of company and Cost of Debt which is % of debt in the capital structure of the company.
The formula is:
WACC = [Ve/ (Ve + Vd)] * Ke + [Vd/ (Ve + Vd)] * Kd (1-t)
Ve = Value of equity
Vd = Value of debt
Ke = Cost of equity (It comes from CAPM- Capital Asset Pricing model)
Kd = Cost of debt
t = Corporate tax rate
Which Terminal Value Method is Used more Often?
The Exit Multiple approach is used more often by the industry professionals as they prefer comparing the value of the company to something which can be observed in the market. Theoretically, the perpetual growth model (Gordon Growth Model) is recommended, therefore, some industry experts take a hybrid approach and some use an average of both.
Types of Free Cash Flows
Free Cash Flows to Firm (FCFF)
- FCFF is also called as “Unlevered cash flows”.
- FCFF = Net Income + Depreciation & Amortization + Change in Working Capital – Capex
Free Cash Flow to Equity (FCFE)
- FCFE is also called as “Levered cash flows”.
- Net Income + Depreciation & Amortization + Changes in Working Capital – Capex + Net Borrowings
Also Read: Cash Flow Adjustments for DCF Analysis
Steps to Perform DCF Analysis
- Unlevered FCFs should be projected.
- Discount rate must be calculated.
- Calculate Terminal Value.
- Calculate Enterprise Value by discounting the projected FCFs and Terminal Value to present value.
- Calculate the equity value by subtracting net debt from EV.
- Review the results.
Benefits of Discounted Cash Flow Analysis
- Theoretically, it is the most famous method of valuation.
- It is based on forward looking approach and is more dependent on future expectations.
- It concentrates more on generation of cash flow.
- It can be applied for valuing business as a whole and also for valuing a part of business of a company.
- It includes all major assumptions about the entity.
- It includes all the future expectations of the entity.
- Sensitivity analysis can be done.
- It doesn’t require any comparable company.
Limitations of Discounted Cash Flow Analysis
- It is more exposed to errors.
- It needs a lot of assumptions.
- It can lead to complexities.
- It doesn’t consider the relative valuation of the competitors in the market.
- The value calculated by DCF is dependent on the quality of assumptions made.
- Terminal Value and Weighted Average Cost of Capital are hard to estimate.
Also Read: Discounted Cash Flow Analysis: Pros And Cons
Discounted Cash Flow method is one of the significant financial tool and method used by most of the companies to derive their value by using the future cash flows of the company. It is a very sensitive method of valuation as it finds out the value of a company today, based on projections of how much money it will generate in the future. Care should be taken while using this method since a small mistake in the assumption of terminal growth rate, beta, risk free rate of return and market return can affect the value of the business significantly.