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Valuation Method 3: Discounted Cash Flows

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment today, based on projections of how much money it will generate in the future. Cash flow refers to the cash generated by a business which can be paid out to investors or reinvested into the business, and in the context of a DCF analysis, free cash flow, which is the cash that is available to both debt and equity investors, is used. This cash flow is then discounted back to a specific point in time, typically to the current date, and this is to account for opportunity cost and risk. For simplicity, the opportunity cost can be thought of as the firm’s Weighted Average Cost of Capital (WACC). This is because the WACC represents investor’s required rate of return, meaning that if the firm is unable to find a higher return rate elsewhere it should buy back its own shares.

 

Steps in Building a simplified DCF Model:

Step 1: Building a forecast

The first step in the DCF model process is to build a forecast of the three financial statements based on assumptions about how the business will perform in the future. On average, this forecast typically goes out about five years. The forecast has to build up to unlevered free cash flow (free cash flow to the firm or FCFF). We’ve published a detailed guide on how to calculate unlevered free cash flow, but the quick answer is to take EBIT, less capital expenditures, plus depreciation and amortization, less any increases in non-cash working capital.

The first step in a DCF model involves using the three financial statements to build a forecast about how the business will perform in the coming 5 years. This forecast builds up to the unlevered free cash flow (AKA Free Cash Flow to the Firm, or FCFF), which can be calculated by the following formula:

NOPAT + D&A – CAPEX – Δ Net WC

Forecasting Revenue, Expenses, Capital Expenditure and Change in Working Capital to build the model:

There are several ways to build a Revenue and Expense forecast, but the simplest way is that of a growth-based forecast, in which the year over year growth rate can be used to forecast revenues for the coming years. Capital Expenditure (CapEx) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment, and is often used to undertake new projects or investments by a company. Working Capital Reserve (WCR) is the difference between the firm’s Current Assets (CA) and Current Liabilities (CL), and it is a measure of the company’s liquidity

Step 2: Terminal Value

The terminal value is a very important part of a DCF model. It often makes up more than half of the net present value of the business, especially if the forecast period is 5 years or less. There are two ways to calculate the terminal value: the perpetual growth rate approach and the exit multiple approaches. 

The perpetual growth rate assumes that the cash flow generated at the end of the forecast period grows at a constant rate forever. So, for example, the cash flow of the business is $10 million and grows at 2% forever, with a cost of capital of 15%. The terminal value is $10 million / (15% – 2%) = $77 million.

With the exit multiple approach, the business is assumed to be sold for what a “reasonable buyer” would pay for it. This typically means an EV/EBITDA multiple at or near current trading values for comparable companies. As you can see in the example below, if the business has $6.3 million of EBITDA and similar companies are trading at 8x then the terminal value is $6.3 million x 8 = $50 million. That value is then discounted back to the present to get the NPV of the terminal value.

Step 3: DCF for Enterprise Value (EV) compared to Equity Value

When building a DCF model using unlevered free cash flow, the NPV that you arrive at is always the enterprise value (EV) of the business. This is what you need if you’re looking to value the entire business or compare it with other companies without taking into account their capital structures. However, if you’re looking for the equity value of the business, you take the net present value (NPV) of the unlevered free cash flow and adjust it for cash and equivalents, debt, and any minority interest. This will give you the equity value, which you can divide by the number of shares and arrive at the share price.

Written by: Ethan Liew (by Assembly Works)

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