Discounted Cash Flow (DCF) is a methodology used to value of an asset, based on the net present value of its projected future cash flows. It uses long-term cash flows and risk to calculate current values of businesses. DCF is widely used in many fields such as corporate finance, investments, business development, capital budgeting and even academics. A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity.
DCF valuation is characterized by three main steps which are
- Confirm historical finance statements for accuracy.
- Validate all important assumptions for future projections.
- Sensitize all variables which control the projections.
- If assumptions are valid, it is the most accurate method.
- Non-economic factors and temporary market conditions do not contribute to the calculated result.
- It is beneficial when comparisons are none or few.
- DCF analysis allows different components of a business or synergies to be valued separately.
- The computed values are very sensitive to assumptions. There is no concrete analysis.
- A DCF model is only as good as its input assumptions.
Key Projections and Assumptions
The important assumptions which have to be made are given below:
- Free Cash Flow: This is the amount of cash left after all total expenditures have been made including operation and capital costs.
- Terminal Value: The value of business at the end of the projection period, assuming stable growth.
- Discount Rate: The weighted average cost of equity and debt for the organization.
There are a few points which need to be kept in mind whenever performing DCF:
- Perform intensive research when you are making assumptions.
- Incorporate details and footnotes in your analysis.
Approach to a DCF Analysis
The cash flows can be projected by using any of the two methods available, which are unlevered and levered DCF. Many prefer using the unlevered cash flows. This makes it easier to compare different companies because unlevered DCF represents a whole value of the company without any regard to its capital structure.
The following points are important when using the unlevered DCF approach:
- Project free cash flows before considering the impact of debt and cash.
- DCF valuation gives the value of the business assuming no debt or cash.
- Use the Weighted Average Cost of Capital (WACC) to discount future cash flows.
- The resulting value is called the Enterprise Value of the business.
- The free cash flows must be projected after considering the effects of interest income and expense.
- Use the Cost of Equity concept to discount future cash flows.
- The resulting value is termed the Equity Value or Market Value of the business.
- Projections: Project out future cash flows. Use a time period of 5 to 10 years for your evaluation. Increasing the time period will decrease the probability of your predictions.
- Terminal Value: Solve using the Terminal Growth Multiple technique or Perpetuity method.
- Discount Rate: Calculate the discount rate by using the Weighted Average Cost of Capital (WACC) value.
- Present Value: Estimate the enterprise value of the organization by discounting the cash flows and terminal values to the present year.
- Adjustments: Deduct the net debt and other adjustments from the enterprise value to obtain the market value.
Sources of DCF Information
- Company financial statements and reports.
- Risk free rate obtained from 10 year treasury rate.
- Cost of Debt obtained company 10-K and 10-Q reports.
- Beta value – measure of correlation between security prices and market value.
- Market risk from industry reports.
- Financial projections and management estimates.