Discounted cash flow analysis
Discounted cash flow analysis (DCF) is a fundamental valuation methodology broadly used by investment bankers, corporate officers, university professors, investors, and other financial professionals. It is premised on the principle that the value of a company, division, business, or collection of assets (target) can be derived from the present value of its projected free cash flow (FCF). A company’s projected FCF is derived from a variety of assumptions and judgments about its expected financial performance, including sales growth rates, profit margins, capital expenditures, and networking capital (NWC) requirements.
In a DCF, a company’s FCF is typically projected for a period of five years. The projection period, however, may be longer depending on the company’s sector, stage of development, and the underlying profitability of its financial performance. In addition, a terminal value is also used to capture the remaining value of the target beyond the projection period (going concern value).
The FCF and the terminal value are discounted to the present at the target’s weighted average cost of capital (WACC), which is a rate that takes into consideration the company’s business and financial risks. The present value of the FCF and terminal value are summed to determine the enterprise value. The assumptions regarding WACC, and terminal value have a substantial impact on the output. As a result, a DCF value should be calculated based on a variety of assumptions and viewed as a range of different values (sensitivity analysis).
Summary of discounted cash flow (DCF) analysis steps
- Study the target and determine key performance drivers
The first step in performing a DCF, as with any valuation exercise, is to study and learn as much as possible about the target and its sector. Shortcuts in this critical area of due diligence may lead to misguided assumptions and valuation distortions later on. This step involves determining the key drivers of financial performance which enables the analyst to design a defensible set of projections for the target.
- Project free cash flow (FCF)
The goal is to project FCF to a point in the future (usually five years) when the target’s financial performance has reached a steady-state that can serve as the basis for a terminal value calculation.
- Calculate the weighted average cost of capital (WACC)
WACC or cost of capital should reflect the company´s weighted business and financial risks, i.e., the company’s capital structure. The WACC is used to discount the FCF and terminal value to the present.
- Determine the terminal value
A terminal value is used to determine the remaining value of the target after the projection period. The final year in the projection period represents a steady-state or normalized level of financial performance, as opposed to a cyclical high or low. The two widely accepted methods to calculate a terminal value are exit multiple methods (EMM) and the perpetuity growth method (PGM).
- Calculate the present value and determine the valuation
The target’s projected FCF and terminal value are discounted to the present and summed to calculate its enterprise value. Please note that the company share price is not identical to enterprise value divided by the number of shares. To calculate share price, one needs to do certain adjustments regarding loans and cash, etc.