DCF Simplified

 Discounted Cash Flow (DCF)

What is the Discounted Cash Flow method of valuation?

Discounted Cash Flow is an Asset or a company valuation method based on Income Approach. In this technique, a company’s model is made with forecasts and assumptions which shows how we as an analyst look at the company. When we make forecasts and assumptions for future cash flows it is necessary to factor in the time value of money which means a Dollar made tomorrow is worth less than a dollar today, to give that effect this technique is used, it calculate the present value of the company’s cash flow.

To use this method it is important to estimate:

·         Asset’s life.

·         Cash flow that will occur during the year.

·         Discount rate

 

Advantages	Disadvantages
It is an appropriate method to use when you acquire an asset as excellent investors buy a business rather than investing in a company’s stocks.	It is possible to find that every stock in a market is overvalued using a DCF model and it can be a problem for Equity Analysts and managers of stock portfolios.
It is important to consider the fundamental traits in this method which forces you to give a thought to assumptions you are making while acquiring the asset.	As this method estimates the intrinsic value it demands more input than any other method.

 

It is important to consider two dates while using the DCF method which are:

·         The valuation date: This is the date on which the valuation is to be calculated all the ash flows are adjusted to this date

·         Cash flow Timing: These are the dates when the cash flow occurs, it is assumed that cash flow occurs by the end of each year or each quarter.

 

What are the different types of DCF?

·         Firm valuation (FCFF): Present value is the value of the entire firm, & reflects the value of all claims on the firm, and the discount rate that is used consists of raising both Equity and Debt.

 

FCFF = EBIT – Tax on EBIT +/- Noncash charges and Earnings – CAPEX +/- WC change

 

·         Equity Valuation (FCFE): Present value is the value of just the equity claims on the firm and the Discount rate only consists cost of raising equity.

 

FCFE = FCFF – (interest*(1-tax rate)) +/- Net change in Debt

 

 

What are the steps to calculate the DCF?

1.      Cash Flow Projection

2.      Discount rate/WACC/Cost of Equity Calculation

3.      Calculation of Terminal Value by Gordon Growth method or Exit multiple

4.      Discounting Cash flow and TV using a Discount rate

5.      DCF value = Discounted CF + PV of Terminal value