Discounted Cash Flow
The Discounted Cash Flow (DCF) model is one of the most commonly used models for valuing companies. The model is based on the assumption that a company’s actual value is derived from the future cash flows (free cash flows) available to the investor. However, since these cash flows are expected in the future, the investor must be compensated for the period during which the capital is tied up and cannot be invested elsewhere. In addition, the industry-specific market risk associated with the investment must be taken into account. The discount rate calculated on the basis of these two factors gives the model its name.
The Necessary Steps of the Discounted Cash Flow Model
1. Forecasting future free cash flows
The first step is to forecast future free cash flows. The basis for this calculation is the projected income statement, balance sheet, and, ultimately, the cash flow statement derived from them. This also highlights the major practical challenge associated with business valuation, because future expected revenues from customer orders that have not yet been secured must be forecasted. The period planned in detail as the basis for the business valuation typically covers the next three to five years.
To determine future profit, the company’s costs must then be projected. These include, among other things, expenses for personnel and materials. In order to derive the free cash flows available to the investor from the projected future profit, it is then necessary to forecast changes in individual balance sheet items as well. For example, cash flow differs from profit when investments and depreciation differ from one another, or when working capital balance sheet items such as accounts receivable or inventory change.
2. Discounting the Forecasted Free Cash Flows
To determine the enterprise value, the present value of the projected free cash flows must be calculated. This is achieved by discounting the individual free cash flows using the respective discount rate. In general, it is recommended to use the weighted average cost of capital (WACC), as this reflects all capital costs within the company.
Formula for discounting future free cash flows for the planning phase:
CFn/(1+d)n
CFn: Cash flow in year n
n: Year
d: Discount rate (usually WACC)
3. Calculation of the terminal value
Since free cash flows will continue to be generated even after the period covered by the detailed plan, this must also be taken into account accordingly. Future free cash flows are represented by the so-called terminal value, which is based on the highly simplified Gordon Growth Model. Here, it is assumed that the calculated free cash flow value for the last year will continue to grow at a fixed rate indefinitely.
Calculation formula for the growth model: [FCF × (1 + g)] / (d – g)]
FCF = Free Cash Flow of the last projected year
g = Assumed growth rate
d = Discount rate (usually WACC)
Finally, it is important to note that the terminal value calculated in this way is based on the last year and must therefore be discounted back to the base year, analogous to the discounting performed during the planning phase.
4. Calculation of Enterprise Value
As a final step, the discounted free cash flows and the discounted terminal value must be added together to obtain the value of the company or the investment.
It is also important to note that the value determined using the discounted cash flow model does not always correspond to the value the owner receives for their company. This represents the value of the operating business. If the company is in debt, a buyer taking over the operating business would deduct the assumed debt from the purchase price accordingly. At the same time, cash on hand and cash reserves would remain with the seller.
Summary
The discounted cash flow model is one of the most commonly used methods for business valuation. To minimize potential inaccuracies, the forecast period should be planned as thoroughly as possible. It is important to note that the terminal value often accounts for an extremely large portion of the calculated enterprise value.
With a 5-year planning horizon, approximately 70–80% of the company’s value is attributable to the terminal value. Since, in practice, the greatest planning uncertainty exists in the final year of the forecast—and this year serves as the basis for the calculation—there is a risk that imprecise planning could lead to significant distortions in the valuation.