Valuation using discounted cash flows


Valuation using discounted cash flows is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money.
The cash flows are made up of the cash flows within the forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period.
In several contexts, DCF valuation is referred to as the "income approach".
Discounted cash flow valuation was used in industry as early as the 1700s or 1800s; it was explicated by John Burr Williams in his The Theory of Investment Value in 1938; it was widely discussed in financial economics in the 1960s; and became widely used in U.S. courts in the 1980s and 1990s.
This article details the mechanics of the valuation, via a worked example, including modifications typical for startups, private equity and venture capital, corporate finance "projects", and mergers and acquisitions.
See Discounted cash flow for further discussion, and for context.

Basic formula for firm valuation using DCF model

Value of firm =
where
In general, "Value of firm" represents the firm's enterprise value ; for corporate finance valuations, this represents the project's net present value or NPV.
The second term represents the continuing value of future cash flows beyond the forecasting term; here applying a "perpetuity growth model".
Note that for valuing equity, as opposed to "the firm", free cash flow to equity or dividends are modeled, and these are discounted at the cost of equity instead of WACC which incorporates the cost of debt.
Free cash flows to the firm are those distributed among – or at least due to – all securities holders of a corporate entity ; to equity, are those distributed to shareholders only.
Where the latter are dividends then the dividend discount model can be applied, modifying the formula above.

Use

The diagram aside shows an overview of the process of company valuation. All steps are explained in detail [|below].

Determine forecast period

The initial step is to decide the forecast period, i.e. the time period for which the individual yearly cash flows input to the DCF formula will be explicitly modeled. Cash flows after the forecast period are represented by a single number.
The forecast period must be chosen to be appropriate to the company's strategy, its market, or industry; theoretically corresponding to the time for the company's return to "converge" to that of its industry, with constant, long term growth applying to the continuing value thereafter; although, regardless, 5–10 years is common in practice.
For private equity and venture capital investments, the period will depend on the investment timescale and exit strategy.
See further under Forecast period, as well as [|§ Determine the continuing value] below.

Determine cash flow for each forecast period

As above, an explicit cash flow forecast is required for each year during the forecast period. These must be "Free cash flow" or dividends.
Typically, this forecast will be constructed using historical internal accounting and sales data, in addition to external industry data and economic indicators.
The key aspect of the forecast is, arguably, predicting revenue, a function of the analyst's forecasts re market size, demand, inventory availability, and the firm's market share and market power;
future costs, fixed and variable, as well as capital, can then be estimated as a function of sales via "common-sized analysis".
At the same time, the resultant line items must talk to the business' operations: in general, growth in revenue will require corresponding increases in working capital, fixed assets and associated financing; and in the long term, profitability should tend to the industry average, as mentioned above; see, and.
Approaches to identifying which assumptions are most impactful on the value – and thus need the most attention – and to model "calibration" are discussed below. For the components / steps of business modeling here, see the list for "Equity valuation" under, as well as financial forecast more generally.
There are several context dependent modifications:
Alternate approaches within DCF valuation will more directly consider economic profit, and the definitions of "cashflow" will differ correspondingly; the best known is EVA. With the cost of capital correctly and correspondingly adjusted, the valuation should yield the same result. These approaches may be considered more appropriate for firms with negative free cash flow several years out, but which are expected to generate positive cash flow thereafter. Further, these may be less sensitive to terminal value. See.

Determine discount factor / rate

A fundamental element of the valuation is to determine the appropriate required rate of return, as based on the risk level associated with the company and its market.
Typically, for an established company:
  1. For the cost of equity, the analyst will apply a model such as the CAPM most commonly; see and Beta. An unlisted company’s Beta can be based on that of a listed proxy as adjusted for gearing, ie debt, via Hamada's equation.
  2. The cost of debt may be calculated for each period as the scheduled after-tax interest payment as a percentage of outstanding debt; see.
  3. The value-weighted combination of these will then return the appropriate discount rate for each year of the forecast period. As the weight of debt could vary over the forecast, each date's discount factor will be compounded over the periods to that date.
By contrast, for venture capital and private equity valuations – and particularly where the company is a startup, as in the example – the discount factor is often set by funding stage, as opposed to modeled.
In its early stages, where the business is more likely to fail, a higher return is demanded in compensation;
when mature, an approach similar to the preceding may be applied.
See: ;.
Corporate finance analysts usually apply the first, listed company, approach: here though it is the risk-characteristics of the project that must determine the cost of equity, and not those of the parent company.
M&A analysts likewise apply the first approach, with risk as well as the target capital structure informing both the cost of equity and, naturally, WACC.

Determine current value

To determine current value, the analyst calculates the current value of the future cash flows simply by multiplying each period's cash flow by the discount factor for the period in question; see time value of money.
Where the forecast is yearly, an adjustment is sometimes made: although annual cash flows are discounted, it is not true that the entire cash flow comes in at the year end; rather, cash will flow in over the full year. To account for this, a "mid-year adjustment" is applied via the discount rate, affecting the required averaging.

Determine the continuing value

The continuing, or "terminal" value, is the estimated value of all cash flows after the forecast period.
Whichever approach, the terminal value is then discounted by the factor corresponding to the final explicit date.
Note that this step carries more risk than the previous: being more distant in time, and effectively summarizing the company's future, there is more uncertainty as compared to the explicit forecast period; and yet, potentially this result contributes a significant proportion of the total value.
Here, a very high proportion may suggest a flaw in the valuation ; but at the same time may, in fact, reflect how investors make money from equity investments – i.e. predominantly from capital gains or price appreciation. Its implied exit multiple can then act as a check, or "triangulation", on the perpetuity derived number.
Given this dependence on terminal value, analysts will often establish a "valuation range", or sensitivity table, corresponding to various appropriate – and internally consistent – discount rates, exit multiples and perpetuity growth rates.
For a discussion of the risks and advantages of the two methods, see.
For the valuation of mining projects the forecast period is the same as the "life of mine" – i.e. the DCF model will explicitly forecast all cashflows due to mining the reserve
– and a continuing value is therefore not part of the valuation.

Determine equity value

The equity value is the sum of the present values of the explicitly forecast cash flows, and the continuing value; see and.
Where the forecast is of free cash flow to firm, as above, the value of equity is calculated by subtracting any outstanding debts from the total of all discounted cash flows; where free cash flow to equity has been modeled, this latter step is not required – and the discount rate would have been the cost of equity, as opposed to WACC.
The accuracy of the DCF valuation will be impacted by the accuracy of the various inputs and assumptions.
Addressing this, private equity and venture capital analysts, in particular, apply the following.
With the first two, the output price is then market related, and the model will be driven by the relevant variables and assumptions. The latter two can be applied only at this stage.
The DCF value may be applied differently depending on context.
An investor in listed equity will compare the value per share to the share's traded price, amongst other stock selection criteria. To the extent that the price is lower than the DCF number, so she will be inclined to invest; see Margin of safety and Undervalued stock. The above calibration will be less relevant here; reasonable and robust assumptions more so.
A related approach is to "reverse engineer" the stock price; i.e. to "figure out how much cash flow the company would be expected to make to generate its current valuation... depending on the plausibility of the cash flows, decide whether the stock is worth its going price."
More extensively, using a DCF model, investors can "estimat the expectations embedded in a company's stock price.... then assess the likelihood of expectations revisions."
Corporations will often have several potential projects under consideration, see. NPV is typically the primary selection criterion between these; although other investment measures considered, as visible from the DCF model itself, include ROI, IRR and payback period.
Private equity and venture capital teams will similarly consider various measures and criteria, as well as recent comparable transactions, when selecting between potential investments; the valuation will typically be one step in, or following, a thorough due diligence.
For an M&A valuation, the DCF will be one of several valuation results "combined" into a single number ; thereafter, other factors listed below, will then be considered in conjunction with this value.

Literature

Standard texts
Discussion
Resources