What is a DCF Model?
The discounted cash flow (DCF) model is a type of financial model that values an investment by forecasting its cash flows into the future and calculating the present value of those cash flows by discounting them. Cash flows are discounted using the rate of return determined by the modeler.
The DCF model estimates a company’s intrinsic value (value based on a company’s ability to generate cash flows) and is often compared to the company’s market value. If a company’s intrinsic value is greater than the market value of the company, the stock is said to be undervalued. The converse is that a company valued at less than its market value is unlikely to be a good investment.
Key Learning Points
- A DCF model is built using the income statement, balance sheet, and cash flow statement.
- The model assumes that the company faces a relatively complete market environment, that is, the institutional environment and the operating environment are stable, the company continues to operate, and investors have rational and consistent expectations.
- The DCF is based on assuming that the business is a going concern, meaning that it is expected to continue operations for the foreseeable future.
- DCF analysis is an important and widely used tool for valuation in equity research and corporate finance.
Discounted Cash Flow (DCF) Formula
The theoretical value of a stock is equal to the present value of the cash return you could earn by holding the stock (income method)
CFi: the cash flow for the given year
r: the discount rate
t: time period
Free Cash Flow
The only criterion that an investor should consider in decision-making is not whether a company has a competitive advantage, but whether this competitive advantage can bring more cash to investors in the future. A DCF model can be based on the free cash flow to the firm (FCFF) or the free cash flow equity (FCFE). Free cash flow is the amount of cash a company generates (net of tax) after accounting for non-cash expenses, CAPEX, and any change in operating assets and liabilities. Analysts use free cash flow rather than EBITDA or Net Income because those metrics omit capital expenditures and changes in cash from changes in operating assets and liabilities. Net income is calculated based on non-cash expenses as well, and does not accurately reflect the cash flow to the company. Free cash flow can also be referred to as unlevered free cash flow since it doesn’t take into account interest expense or net debt issuance (repayment).
Free cash flow to equity is also known as levered free cash flow because it takes interest expense and net debt issuance (repayment) into account.
Why is the Cash Flow Discounted?
In a valuation based on discounted cash flow, the present value is usually calculated as of the current date. This model is based on the time value of money, which states that a dollar today is worth more than a dollar in the future. Monday today can be invested to generate a return, which is what makes today’s dollar more valuable.
Cost of Capital
Analysts often use the Weighted Average Cost of Capital (WACC), which represents a company’s average cost of capital including both equity and debt, in DCF models. WACC can be considered the rate of return that stockholders and bondholders require to provide capital. It can also be thought of as a firm’s opportunity cost; if a company can’t find a higher rate of return elsewhere, they should buy back their own shares.
The riskier a company, the higher its WACC.
To the extent a company achieves rates of return above their cost of capital (their hurdle rate), they are creating value. If they are earning a rate of return below their cost of capital, then they are destroying value.
DCF Usage
The DCF model is used widely in practice as well as in academia. A company valuation is a basis for investment and transaction pricing, and investors ultimately make investment recommendations and decisions based on the valuation. This applies to an investor acquiring a company or buying stock. Business owners and managers can make capital budgeting or operating expenditure decisions based on DCF modeling.
The DCF valuation method is the most rigorous method for valuing companies and stocks, and in principle is applicable to any type of company. However, it is usually more suitable for companies with more predictable cash flows.
In contrast with a market-based valuation like a comparable company analysis, the idea underlying the DCF model is that the value of a company is not a function of arbitrary supply and demand for that company’s stock. Instead, the value of a company is a function of a company’s ability to generate cash flow in the future for its shareholders.
Absolute Valuation v.s Relative Valuation
Company value can be estimated by the absolute valuation method and the relative valuation method. In theory, the enterprise value or equity value estimated by various methods should be consistent.
Limitations of DCF
The DCF model’s main limitation is that it requires many assumptions, and is only as good as those assumptions. For example, an investor needs to accurately estimate future cash flows. These future cash flows rely on a multiplicity of factors, everything from market demand and competitive advantage to economic conditions, technology, and potentially, geopolitical considerations. Unforeseen threats and opportunities can both have significant impact on projections.
A cash flow estimate that’s too high can lead to making a bad investment, while an estimate that’s too low can make a company look expensive and cost the investor an attractive opportunity. It’s also vital to choose an appropriate discount rate, which represents the required rate of return on the investment. Future cash flows are reduced by the discount rate, so the higher the rate the lower the present value will be.
Example
Basic DCF calculation
A project has the following cash flows.
T0 Outflow $110,000
T1-4 Inflow $40,000
At the company’s cost of capital of 10%, the NPV of the project is $16,800.
| Year | 0 | 1 | 2 | 3 | 4 |
| Cash flow | -110,000 | 40,000 | 40,000 | 40,000 | 40,000 |
| NPV | 16,794.62 |
Allowing for inflation and taxation in DCF
Taking into account inflation and taxation, the NPV layout will be as follows:
| Year | 0 | 1 | 2 | 3 | 4 | 5 |
| Sales | X | X | X | X | X | |
| Costs | (X) | (X) | (X) | (X) | (X) | |
| Operating cash flow | X | X | X | X | X | |
| Taxation | (X) | (X) | (X) | (X) | ||
| Capital expenditure | (X) | |||||
| Scrap value | X | |||||
| Tax benefit of Cash | X | X | X | X | ||
| Working capital | (X) | (X) | (X) | X | X | |
| Net cash flows | (X) | X | X | X | X | X |
| Discount factors @post-tax cost of capital | X | X | X | X | X | X |
| Present value | (X) | X | X | X | X | X |
Conclusion
DCF valuations depend on factors including cash flow and discount rate while comparative valuations look at comparable companies. In practice, valuation is affected by a multitude of factors, both external and internal. Therefore, analysts typically use multiple relative valuation methods and at least one absolute valuation method, mainly DCF. They also use sensitivity analysis to give a reasonable valuation range and constantly adjust and revise valuation parameters.
The methodological framework of DCF valuation requires users to analyze a company’s fundamentals. The analyst should not only consider the financial status, product structure, and business structure but also consider industry trends and company strategy to come to a comprehensive understanding of the company being valued.
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