Discounted Cash Flow Analysis
How Does Discounted Cash Flow Analysis Work?
Discounted Cash Flow Analysis, often termed 'DCF Analysis', is a valuation method that estimates the value of a company based on its expected future cash flows, adjusting for the time value of money. The time value of money assumes that money today is worth more than the same amount tomorrow, and as a result, the expected future cash flows of the company available to investors, termed 'free cash flow', must be discounted to their present value. DCF Analysis finds the present value of the company's free cash flow by using something called a discount rate. DCF Analysis yields a company's implied Enterprise Value, so in most cases, you subtract Debt and add Cash (or subtract Net Debt) and then divide that number by the total number of shares outstanding to get to the company's intrinsic Share Price.
How Do You Perform a DCF Analysis?
1. PROJECT CASH FLOWS: The first step in a DCF Analysis is to project the company's Free Cash Flows in the Explicit Forecast Period. This Free Cash Flow represents the company's recurring business cash flow and is available to all investors. The Explicit Forecast Period can vary from anything between 5 to 10 years, depending on the company and industry. Usually, the more stable a company is, the shorter its Explicit Forecast Period.
2. DISCOUNT CASH FLOWS: After forecasting the company's cash flows, the next step is to discount these cash flows at the appropriate discount rate in order to account for the time value of money. This discount rate represents the opportunity cost for the investor – what she could potentially make by investing in other similar businesses. A higher discount rate means the company is riskier but also has the potential to generate higher returns. In the context of a DCF Analysis, the discount rate for the company is its Weighted Average Cost of Capital (WACC). The company's WACC will vary depending on the company's risk profile and the conditions of the capital markets.
3. CALCULATE TERMINAL VALUE: The third step is to determine the company's Terminal Value, i.e., the company's value starting from the end of your forecast period to the far future. You need this value because you are assuming that the company will continue operating after your projection period of 5 to 10 years.
4. DISCOUNT TERMINAL VALUE: Once you've calculated the Terminal Value, the next step is to discount it to its present value. You can discount your Terminal Value using the same discount rate used in step 2 for the projected cash flows. Once again, the purpose of discounting here is to account for the time value of money – the Terminal Value of a company represents its value beginning from the end of your forecast period to the far future, as of the end of your forecast period, thus it must be discounted to its present value.
5. DETERMINE ENTERPRISE VALUE: Step 5 is to sum the discounted values (including the discounted cash flow projections from step 2 and the discounted Terminal Value from step 4) to find the company's implied Enterprise Value. As explained in the Equity & Enterprise Value page, Enterprise Value is the value of a company's core business operations that is available to all investor groups.
6. CALCULATE INTRINSIC SHARE PRICE: The final step in a DCF Analysis is to get from the company's implied Enterprise Value to its implied Share Price. To do so, you subtract Net Debt (you can read more about deriving Equity Value from Enterprise Value and vice versa here) and divide by the total number of shares outstanding. You can then compare your calculated implied Share Price with the company's market price to determine whether your company is being over- or undervalued.
Pros & Cons of the DCF Analysis
Captures the underlying fundamental drivers of a business
Derives the intrinsic value of a company
Less reliant on comparable companies
Allows analysts to incorporate key changes to company's business/strategy into the valuation model
Can account for the different growth stages of a company
Requires a large number of assumptions
Very sensitive to assumptions so results can fluctuate
Does not work well if company's operations lack visibility (making it difficult to predict Revenues, Expenses, Capital Expenditures, etc. with certainty)
Terminal Value represents a large portion of the total estimated value, thus small variations to assumptions during that period can have a significant impact on the final valuation
Discount rate can be tough to estimate