Discounted cash flow (DCF) is a fundamental valuation analysis used widely 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 into the future.
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
The process for undertaking a DCF analysis can be summarized by the following steps:
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.
The free cash flow calculation is as follows:
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