A discounted cash flow model (DCF model) is a type of financial model that values a company by forecasting its’ cash flows and discounting the cash flows to arrive at a current, net present value.  Moreover, Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows.

 

DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. This applies to the decisions of investors in companies or securities, such as acquiring a company, investing in a technology start-up, or buying a stock, and for business owners and managers looking to make capital budgeting or operating expenditures decisions such as opening a new factory or purchasing or leasing new equipment.

 

In other words, we can say that DCF analysis is an intrinsic valuation method used to estimate the value of an investment. It establishes a rate of return or discount rate by looking at dividends, earnings, operating cash flow or free cash flow that is then used to establish the value of the business outside of other market considerations. 

 

The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow because it can be invested. As such, a DCF analysis is appropriate in any situation wherein a person is paying money in the present with expectations of receiving more money in the future. The DCF has the distinction of being both widely used in academia and in practice. Valuing companies using the DCF is considered a core skill for investment bankers, private equity, equity research and “buy side” investors.

 

Advantages

  • Extremely detailed

  • Includes all major assumptions about the business

  • Determines the “intrinsic” value of a business

  • Does not require any comparable companies

  • Can be performed in Excel

  • Includes all future expectations about a business

  • Suitable for analysing mergers and acquisition

  • Can be used to calculate the internal rate of return IRR of an investment

  • Scenarios can be built-in

  • Allows for sensitivity analysis

 

Disadvantages

  • Requires a large number of assumptions

  • Prone to errors

  • Prone to overcomplexity

  • Very sensitive to changes in assumptions

  • A high level of detail may result in overconfidence

  • Looks at company valuation in isolation

  • Doesn’t look at relative valuations of competitors

  • Terminal value is hard to estimate and represents a large portion of the total value

  • Challenging to estimate the Weighted Average Cost of Capital (WACC)

 

The main limitation of DCF is that it requires many assumptions. For one, an investor would have to correctly estimate the future cash flows from an investment or project. The future cash flows would rely on a variety of factors, such as market demand, the status of the economy, technology, competition, and unforeseen threats or opportunities.

 

Estimating future cash flows to be too high can result in choosing an investment that might not pay off in the future, hurting profits. Estimating cash flows to be too low, which would make an investment appear costly, could result in missed opportunities. Choosing a discount rate for the model is also an assumption and would have to be estimated correctly for the model to be worthwhile.

 

Discounted Cashflow Modelling is the widely used financial analysis model due to its added advantages over other valuation methods like Relative Valuation and Precedent Transactions Valuation. 

Process of carrying out DCF Valuation

  1. Setting up the assumptions

  2. Forecasting the financial statements based on the assumptions

  3. Preparing Fixed Assets Schedule

  4. Preparing Working Capital Schedule

  5. Preparing Depreciation & Amortization Schedule

  6. Computation of Weighted Average Cost of Capital

  7. Computation of Free Cash Flows

  8. Computation of Terminal Value

  9. Computation of NPV and Intrinsic Value

 

Assumptions

While carrying out valuation of any company, we have to adhere to several assumptions on the basis of which future cashflows are projected. These assumptions are related to the top-line and bottom-line factors of a P&L statement and other financial statements. 

 

These assumptions are based on both historical performance and the future growth prospects of the company. Along with that, overall economy and industry outlook is equally important while formulating the assumptions.

 

Assumptions are generally formulated considering

  1. Revenue Outlook

  2. Cost and Expense Outlook

  3. Long term growth rate 

  4. Depreciation and Amortization

  5. Capital Expenditure

  6. Working Capital Requirements

 

Forecasting the Financial Statements

 

Financial forecasting is the process of estimating or predicting how a business will perform in the future. The most common type of financial forecast is an income statement, however, in a complete financial model, all three financial statements are forecasted.

 

There are three major financial statements of a company i.e., Income Statement, Balance Sheet and Cash Flow Statement. 

 

On the basis of the formulated assumptions, we forecast the financial statements for next 5-10 years depending upon the industry. 

This robust forecasting helps us to understand the industry in a deeper sense and value the company with more accuracy.

 

Fixed Assets Schedule

 

Fixed Asset Schedule is an integral part of the annual accounts of the company that includes a list of all fixed assets in the business. It acts as a source document that shows closing balances of all fixed assets available at the end of the Financial Year.  

 

A fixed asset schedule is the subset of forecasting the capital expenditures that a company plans to takes into consideration. 

 

Capital expenditures’ nature differs from industry to industry. Thus, we have to account for each type of capital expenditures that a company transacts. 

 

Working Capital Schedule

 

Working Capital is the capital of a business which is used in its day-to-day trading operations. It is simply the difference between current assets and current liabilities. 

 

Working capital schedule takes into account all the current assets and current liabilities from the historical data and looks for company’s short term loan obligations that a company is willing to take in future years. 

 

WC = Current Assets – Current Liabilities 

 

Depreciation and Amortization Schedule

 

Depreciation and Amortization are types of expense that is used to reduce the carrying value of tangible and intangible assets respectively. It is an estimated expense that is scheduled rather than an explicit expense. 

 

Depreciation and Amortization plays an important role while calculating free cash flows as it is a non-cash expense.

 

Weighted Average Cost of Capital

 

WACC, or Weighted Average Cost of Capital, is a financial metric used to measure the cost of capital to a firm. It is most usually used to provide a discount rate for a financed project, because the cost of financing the capital is a fairly logical price tag to put on the investment. WACC is used to determine the discount rate used in a DCF valuation model.

 

WACC = Cost of Equity*Weight of Equity + Cost of Debt*Weight of Debt

 

Free Cash Flows

 

Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.

 

There are two types of FCFs

  1. Free Cash Flows to Firm: It accounts for both the debt and equity components of the capital structure.

  2. Free Cash Flows to Equity: It just accounts for the equity component of the capital structure.

 

FCF = EBIT*(1-Tax Rate) + Depreciation & Amortization – Increase in Working Capital – Capex

 

Terminal Value

 

Terminal value (TV) is the value of a business beyond the forecasted period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. 

 

It can be calculated using two methods

  1. Gordon Growth Approach 

                                      TV = Cashflow*(1-GrowthRate)/(WACC-GrowthRate)

  1. Exit Multiples Approach

                                      TV = EBITDA*(EV/EBITDA Multiple)

 

NPV and Intrinsic Value

 

Using the FCFs and Terminal value, we have to discount them to present day through WACC. After arriving at NPV, we deduct net debt and reach at the equity value. By dividing this equity value by outstanding shares, we reach the fair value of the company’s share.