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 into the future.
Key Learning Points
- Discounted cash flow (DCF) analysis is a useful absolute valuation model in finance
- It calculates the value of a business as the present value of the free cash flows it is expected to generate into the future
- The method is cash flow based rather than focusing on earnings
- It relies on many assumptions and the valuation outcome is very sensitive to any changes in these
- The model assumes that a large proportion of a company’s value is captured by the terminal value; this is very sensitive to changes in growth rates
- It is an absolute valuation methodology but should always be benchmarked against market valuation tools
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
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.
The Free Cash Flow Calculation
|Free Cash Flow =|
|EBIT||Normalized operating profit|
|–||Tax on EBIT||EBIT * Long run tax rate|
|=||NOPAT / EBIAT||Net operating profit after tax / earnings before interest and after taxes|
|–||Capex||Investments in PP&E|
|+/-||Change in OWC||Cash used by / released from OWC investment|
|+/-||Other||Cash flow from changes in other operating assets / liabilities|
|=||Free Cash Flow||Cash flow produced by operations / available for all providers of capital|