A 9 Step Guide to Discounted Cash Flow (DCF) Model

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What is Discounted Cash Flow (DCF)?

Discounted Cash Flow (DCF) is a method of valuing a company or project by estimating its future cash flows and discounting those back to present value. It is used to determine the present value of future cash flows and to determine the expected return on investment.

How Does Discounted Cash Flow Work?

DCF is based on the idea that money today is worth more than the same amount of money in the future. This is because money today can be invested to earn a return, which means that it has the potential to grow. The discount rate used in DCF is the rate of return required to make the present value of future cash flows equal to the current cost of the investment.

9 Steps to Perform a Discounted Cash Flow Analysis

Step 1: Calculate Free Cash Flows

This is the first step in creating a DCF model. Forecasting free cash flows involves projecting the amount of cash the asset will generate over a five to ten-year period. This is done by using historical data and making assumptions based on the information. To calculate free cash flows, sum up the numbers in the free cash flow column. The formula for free cash flow is EBIT – Tax + Depreciation & Amortisation – Capex +/- change in non-cash working capital.

Step 2: Determine the Cost of Equity

The cost of equity is an important component of the DCF model. It represents the expected return an investor would require for investing in the company. To determine the cost of equity, the formula is Risk-Free Rate + (Beta * (Market Return – Risk-Free Rate)).

Step 3: Determine Debt and Equity Proportions

The next step is to determine the proportions of debt and equity in the company’s capital structure. The debt proportion is calculated by dividing the value of debt by the sum of debt and equity. Similarly, the equity proportion is calculated by dividing the value of equity by the sum of debt and equity.

Step 4: Determine the Weighted Average Cost of Capital (WACC)

The WACC is a measure of a company’s cost of capital, and it represents the average cost of all the capital that the company has raised. The formula to calculate the WACC is (Equity * Cost of Equity) + (Debt * Cost of Debt) * (1 – Tax Rate).

Step 5: Calculate the Present Value of Free Cash Flows

The next step is to discount the free cash flows back to the present. The discount factor is calculated by using the formula 1 / (1 + r), where r is the WACC. Once the discount factor is calculated, multiply each free cash flow by the discount factor to get its present value.

Step 6: Calculate the Terminal Value

The terminal value represents the future value of the company’s cash flows after the end of the forecasting period. We have two types to terminal value, perpetuity growth terminal value that assumes the cash flow will grow at a steady rate forever and exit multiple terminal value assumes a company is sold using a multiple of a metric eg EBITDA.

To calculate the exit multiple terminal value, multiply the EBITDA by the EV/EBITDA multiple.

To calculate the perpetuity growth terminal value, multiple the (Free Cash Flow * (1+g))/(WACC-g). where g is the industries growth rate or the respective country’s growth rate.

Step 7: Calculate the Enterprise Value

The enterprise value represents the sum of the present value of free cash flows and the terminal value. The enterprise value is calculated by summing up the present value of free cash flows and the terminal value.

Step 8: Determine the Equity Value

The equity value represents the value of the company’s equity after accounting for debt and cash. The equity value is calculated by subtracting debt and cash from the enterprise value. The formula is Enterprise Value + (Cash + Marketable Securities) – (Short-term Debt + Long-term Debt).

The final step is to determine the implied share price. The implied share price represents the value of a share of the company’s stock. It is calculated by dividing the equity value by the number of shares outstanding.

Advantages of Using Discounted Cash Flow

Accurate valuation: DCF provides a more accurate valuation of a company or project compared to other methods, such as price-to-earnings ratios.
Consideration of future performance: DCF takes into account the potential future performance of the investment, which can be important when making investment decisions.
Consideration of risk: DCF incorporates the risk associated with the investment into the analysis, which can help to make more informed investment decisions.

Disadvantages of Using Discounted Cash Flow

Complexity: DCF can be a complex process, requiring a deep understanding of the investment and its potential future performance.
Difficulty in estimating future cash flows: Accurately estimating future cash flows can be challenging, and small changes in the estimated cash flows can have a large impact on the overall valuation.
Reliance on assumptions: DCF relies heavily on a number of assumptions, such as the discount rate, which can make the results less reliable.

Conclusion

Discounted Cash Flow (DCF) is a valuable financial tool that can be used to determine the present value of future cash flows and to make better investment decisions. However, it is important to understand the complexities and limitations of DCF before using it for financial analysis.