Discounted Cash Flow (DCF) Valuation
What is the discounted cash flow (DCF) Valuation?
A Discounted cash flow valuation is a method to value a company or business by forecasting future cash flows from the business and then discounting the cash flows to current time period to arrive at the present value of business. The present value of cash flowstill perpetuity(over the long term) is the intrinsic value of the Company. It is also called Intrinsic Valuation.
Estimating future cash flows requires a good understanding of the industry, business and the economy. This method gives a rough ball-park number based on the cash flow generation capacity of the business.
It is generally used by investors and equity analysts to understand/assess the true intrinsic value of a Company or business. The value derived from DCF valuation is compared with the market value of the Company to determine whether the Company is under or overvalued.
Where can we use discounted cash flow (DCF) Valuation?
Discounted cash flow valuation can be used for multiple things.
- Evaluation of valuation of a company or business
- Evaluation of a project or investment
- For Bond Valuation
- Valuation of Shares of a Company
How to Discount future cash flows?
The discounted cash flow method involves forecasting the future cash flows from a business and then discounting those cash flows to the present period.
DCF Valuation =
Present value of cash flows = CF / (1+r)^t
Where, CF = Net Cash Flow at the end of year t
t = Time period (year)
r = discount rate or the cost of capital
Present value of cash flows takes into consideration the Time value of money. This means that money received today is not equal to the same amount receivable after one year. This is because of inflation and other investment opportunities that are available.
The concept of Time value of Money is important for making investment decisions.
Steps to build a discounted cash flow Model.
Building a Discounted cash flow model involves the following steps.
- Understand the business
- Analyze the historical performance of the Company
- Forecast future cash flows
- Calculate Terminal Value
- Discounted future cash flows using the Weighted Average Cost of Capital (WACC)
Let us understand each of these steps one by one.
Understand the Business
A discounted cash flow valuation requires a good understanding of the business of the Company, industry and other external factors. Without proper knowledge of the business it is difficult to make assumptions for the DCF valuation.
For example, forecasting the Metal prices and volume growth for a Steel Company to estimate the future revenues. Or forecasting the capex required for 5G Licenses for a Telecom Company can only be done with a good knowledge of the business and industry.
Along with the business it is also important to understand the strategic priorities of the management. Whether it is increasing growth through the introduction of new products or geographies or increasing sales of existing products, cost reduction to improve returns/ margins, reducing leverage, etc. These priorities are usually linked to the cash flows/ shareholder returns and therefore are important for the DCF valuation.
Analyze Historical Financial performance
Analyzing historical performance is very important to understand how the Company has performed on Growth, Margins, and Return on invested Capital. Understand the historical performance helps in forecasting the future cash flows of the business.
An analyst typically looks at the historical performance of the Company and peers for 3 to 5 years to understand the drivers behind it’s under/out performance.
Apart from performance, it is also important to understand the operating drivers like capacity, utilization, etc., and balance sheet strength by looking at liquidity, leverage, coverage ratios, and credit rating of the Company. Operating drivers help build a bottom-up forecast while balance sheet strength helps determine the riskiness in the business.
Project Future cash flows
Once a good understanding of the business and historical performance is developed, the analyst should start projecting the future cash flows of the business. Cash flows can be projected based on Top down or bottom up approach. A top down approach is a high-level approach where the model starts with the revenues and ends at free cash flows. Projections are made based on historical performance (revenue growth and margins) or using management forecasts as a starting point.
A bottom-up approach is a detail approach. Here the analyst forecasts the revenues based on operating drivers. Like, Customer growth, churn rate and ARPU (Average revenue per user) for a telecom Company. Demand projection, Plant wise Production growth and Metal prices for a Metals and Mining Company. Similarly, expenses and capex are forecasted at granular level to calculate the free cash flows.
A discounted cash flow model requires cash flow forecast till perpetuity, which is not practically feasible. An analyst usually forecasts the future cash flows for 5 years. For startups, cash flows are projected for a longer period (7-10 years) till the business has become mature (ie; cash flows from the business have stabilized). Once the cash flow projections are made, we need to calculate the terminal value, which is our next step for the DCF modeling.
Terminal Value Calculation
A business is usually considered as a going concern. Going concerned means that the business will continue till perpetuity. Since it is not feasible to project the future cash flows to perpetuity due to several uncertainties, we calculate the terminal value of the business after the forecasting period (3-10 years). Terminal value is the value of the business beyond the cash flow forecasted period.
Terminal Value can be calculated by 2 approaches: –
- Perpetual growth method
- Exit Multiple
In perpetual cash flow growth method, it is assumed that cash flows will grow at a stable rate till perpetuity.
Terminal value by this method is calculated with the following formula.
Where free cash flow is the cash flow for the last forecasted year.
g = Growth rate till perpetuity
WACC = Weighted average cost of capital or Discount rate
The perpetual growth method assumes that cash flows grow at a certain rate forever. This may not apply in all the industries.
In the Exit multiple methods, we look at the average historical multiples (EV/EBIT, EV/NOPAT, etc.) of the company and transaction multiples for deals in the same industry (Transaction value/ EBITDA, etc.). We use these multiples as a ball-park number to estimate the terminal value of the business.
Discount the future cash flows using Cost of Capital
Before diving deep into the Cost of capital, let us first understand what the time value of money is. Time value of money means that cash flows received today are worth more than cash flows to be received in the future. This is because of inflation and other investment opportunities which the investor may have.
For example, If you receive $1,000/- today you can invest it in a bank deposit. You get $1,050 after one year (assuming a 5% interest rate). That means $1,000/- received today is equal to $1,050 received after one year.
In the DCF model, we forecast cash flows for the future, therefore we discount those cash flows to present time period to calculate the present value of cash flows. Future cash flows are discounted at weighted average cost of capital (WACC) of the Company.
Present value of cash flows till perpetuity is the value of the business.
Present value can be calculated with the help of the following formula.
Where, WACC = Weighted average cost of capital or discount rate
n = time-period/ years for which the cash flows are discounted
To learn more about the cost of capital, please refer to the Weighted Average Cost of Capital
Calculation of Equity Value of the Company
Once we calculate the present value of cash flows till perpetuity, we add the cash, investments available with the Company. In case, the Company has any debt and debt equivalents (preference shares, financial liabilities, etc.) in its books, they are reduced from the total value to derive the equity value of the Company (based on DCF valuation).
This value is compared to the current market capitalization of the company to determine whether it is under or overvalued.