Discounted Cash Flow (DCF) Valuation
February 2, 2024
What is a “Discounted Cash Flow (DCF)”?
Discounted cash flow (DCF) is a fundamental valuation analysis, widely used in the world of finance. It is based on the principle that the value of a business is a function of the present value of the cash flows it is expected to produce in the future.
Key Learning Points
- DCF analysis is an important and widely used tool for valuation in equity research and corporate finance
- DCF analysis is an important and widely used tool for valuation in equity research and corporate finance
- A DCF model is initially built from a forecast of the income statement, balance sheet and cash flow statement of a company
- Forecasting cash flows into the long distant future is highly subjective, so once the company is thought to have reached a stead state, broad assumptions are used to calculate the ‘Terminal Value’ of the business
- The DCF model discounts forecast cashflows. The discount rate is usually the weighted average cost of capital
Simple Discounted Cash Flow (DCF) Formula
Forecast CF: the forecast cash flows for the explicit forecast period, typically 5 or 10 years, although this may differ depending on the company and industry.
Terminal Value: The value of the company at the end of the detailed forecast period. This represents the value of all cash flows after the explicit forecast period. It requires the modeler to be satisfied that the company has settled into a steady state. For a detailed look at moving from the explicit to terminal phase see our blog on terminal value complexities.
r: The discount rate, which is usually the weighted average cost of capital, or WACC
t: Time period. This is commonly a year end, but could be half years, or even months. Shorter periods are helpful if more detail is needed (for example, equity researchers may create quarterly models) or to model mid-year cashflows
Discounted Cash Flow Steps
The process for undertaking a DCF analysis can be summarized by the following steps:
- Forecast free cash flows to steady state (normally 5 or 10 years)
- Calculate Weighted Average Cost of Capital (WACC)
- Calculate terminal value
- Discount cash flows to today
- Calculate implied share price from enterprise value using the bridge
The first step involves forecasting the cash flows to be discounted. These cash flows, referred to as free cash flows or unlevered free cash flows, are generated by the operational business and available to all providers of finance.
Free Cash Flows are generally forecast for five or ten years to steady state. The company reaches a steady state when all sources of competitive advantage are exhausted, and its profitability and efficiency ratios are stabilized. The steady state period also coincides with the end of the explicit forecast of the DCF analysis, and the value of steady state cash flows can be summarized in a single number, called the terminal value.
These forecast cash flows and the terminal value are then discounted to present value using a discount rate that is commensurate with the risk associated with their generation. Since the financing of the operational business is provided by both debt and equity then the discount rate used is the weighted average cost of capital or WACC.
Since the cash flows being discounted are “free” from the effects of financing and are available to both the debt and equity finance providers, the answer is equivalent to enterprise value. The final step is to derive equity value from enterprise value (enterprise value to equity value bridge) and calculate the implied share price.
Which Cash Flows?
A DCF model most often uses unlevered free cash flow for the forecast cash flows in the detailed forecast period. This can also be referred to as free cash flow to the firm (FCFF). You are likely to see these described as free cash flow without the writer specifying they are unlevered. Unlevered cashflows are so commonly used it’s often assumed that free cash flows will be of this type.
Forecast unlevered FCF is the amount of cash a company is expected to generate after accounting for from its operations before any transactions with sources of finance. It is also the amount of cash that the company can use to pay returns to its equity and debt holders, which is why it is used as the basis for valuing the company. If unlevered free cash flows are used, the DCF model will calculate the company’s Enterprise Value, the value within the business for both debt and equity investors
Within a DCF model it is typically calculated by taking EBIT from the forecast income statement and adjusting this for non-cash expenses (such as depreciation and amortization), capital expenditure and any change in operating assets and liabilities, which unwinds the effects of the accruals accounting within the income statement.
An alternative cash flow which is occasionally used is free cash flow to equity, which adjusts FCFF for cash flows to debt holders, such as interest payments and issuance or repayment of debt. This can also be referred to as levered free cash flow. If this cash flow is used, the DCF model will calculate the equity value of the business, since the model will be using the future cash flows available to the equity holders only.
Terminal Value
Beyond the initial detailed forecast period, DCF models typically use broader assumptions to value what happens into the future. The assumption is that the company will have reached a steady state, with more predictable revenue growth rates, profit margins and capex requirements. The terminal value can be calculated using valuation multiples (such as EV / EBITDA) or a growing perpetuity, which assumes the cash flows of the company grow at a constant rate into infinity. The growing perpetuity approach uses the following formula:
Terminal Value =Final forecast CF x (1+g)(r−g)
Final forecast CF: This is the final period cash flow from the initial detailed forecast period
g: The constant growth rate of the cash flows in perpetuity
r: The discount rate
Why are the Cash Flows Discounted?
Cash flows in the future are not worth the same as cash flows today. So, to be able to determine the value of a company today, the forecast future cash flows need to be turned into their equivalent present value.
Which Discount Rate to Use?
To present value the cash flows within a DCF model, analysts typically use the Weighted Average Cost of Capital (WACC), which represents the company’s average cost of capital, taking into account the required return of both equity and debt investors. However, the WACC should only be used if the cash flows included in the DCF model are the unlevered cash flows. These cash flows are available for both debt and equity investors and therefore a discount rate needs to be used which takes into account based the required return of debt and equity investors.
If a DCF model includes the levered free cash flows, then the cost of equity must be used as the discount rate, since the levered cash flows are only available to the equity investors in a company.
Care must be taken in determining the discount rate to be used within a DCF model, since DCF valuations are highly sensitive to their input assumptions, with the WACC being one of the most critical.
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.
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 and these future cash flow estimates rely on a very high number of factors, everything from market demand and competitive advantage to economic conditions, technological change, and potentially, geopolitical considerations. Unforeseen threats and opportunities can both have significant impact on projections. DCF sense checks allow you to test your assumptions and improve your model.
A forecast cash flow that’s overly optimistic can lead to bad investment decisions, while an estimate that’s too low can make a company look expensive and cost an investor an attractive investment opportunity. It’s also vital to choose an appropriate discount rate, which represents the required rate of return on the investment. Present cash flow values are lower than future values, and the higher the discount rate the lower the present value will be.
Examples
Free cashflows
First the model has been built up (see download for the full file). The model has given enough information to build up the forecast free cashflows, see below.
Terminal value
The terminal value is calculated using the WACC, growth rate and a growing perpetuity. Notice it’s on the final column. It’s the value of the terminal cashflows on 31/12/28, and still needs to be discounted back to the investment date.
Enterprise Value
The explicit forecast phase (the first 10 years) is discounted. It’s added to the discounted terminal value. This has created the enterprise value as it represents the present value of all operational cashflows.
Advantages vs Disadvantages
DCF analysis has both strengths and weaknesses. Its strengths include:
- The requirement to think about and forecast key business drivers leads to a fuller understanding of the fundamentals
- It is an important counterpoint to market-based valuation techniques (avoiding some of the possible market distortions)
- It is cash-flow-based rather than earnings led
Its disadvantages include:
- The requirement to make many assumptions about the business
- It can take some time to build (depending on the detail)
- The valuation is very dependent on key assumptions with even small changes producing large value variations
Conclusion
DCF valuations depend on forecasting company specific cash flows and discount rates, resulting in an intrinsic value of the company. These valuations are affected by a multitude of factors, both external and internal. What DCF models do not take into account is current market conditions, which is why alternative relative valuation approaches, such as the multiples approach, are also used. DCF models can make use of sensitivity analysis to flex the input assumptions to give a range of valuations under different input scenarios.
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.
Our investment banking course goes into much more detail on this and many other topics and will teach