DCF Model – Calculating Discounted Cash Flows
A Discounted Cash Flow (DCF) model is a popular financial model used to estimate the value of a company in order to assess the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at their present values, which is used to evaluate the potential for investment by comparing the asking price vs. the valuation result. The proposed investment is considered attractive, if the value arrived through DCF model is higher than the current cost of the investment. If there are several opportunities, the investment proposal with highest difference between value arrived with DCF and current cost of investment shall be selected. Such difference can also be called Present Value.
Step 1 – Calculation of Historical Cash flows
You might be wondering why we should calculate historical cash flows if DCF analysis is all about discounting future free cash flows? – It is relevant because DCF analysis is based on the two major components: Discount Rate and Growth Rate. Existing data is required to at least validate our assumptions going forward. Also, one should never do a DCF analysis without first analysing the company’s historic financials in order to obtain a better understanding of the company and the industry it operates in.
Free cash flows are the cash available for distribution to investors and lenders. There are two types of free cash flows:
- Unlevered Free Cash Flows (UFCF): It is the cash flow available to investors and lenders without taking into account the financing structure (debt/equity) of the business. The magic formula is:
UFCF = EBIT(1-T) – CapEx + Depreciation & Amortization – Change in Net Working Capital
- Levered Free Cash Flows (LFCF) : It is the cash flow available only to investors in the equity portion of capital structure meaning available only to shareholders.
LFCF = UFCF – Interest Exp + Change in Financial Debt
- EBIT (Earnings before Interest and Taxes) should be normalized first as historic profits might be affected by extraordinary items.
- t stands for the effective historic tax rate which often can be very different between historic and future cash flows
- CapEx stands for capital expenditures, which means investments in tangible and intangible assets as those are cash relevant but will not show up in the company’s profits (measured by EBIT)
In both the formulas, we have taken EBIT (1-t) and not net income. Operating profit best represents company operations and hence EBIT is used. Taxes and capital expenditures are deducted as they are both cash operating expenses. Depreciation and Amortization are added because they are non-cash expenditure. Whereas an increase in net working capital is subtracted as cash needs to be invested in inventory, receivables etc.
With levered cash flow, subtract interest expense + change in debt financing (which together equals the debt service) as the distribution is to be made only to the equity investors and hence, the effect from debt service has to be excluded.
Investment banks and investors generally use Unlevered Free Cash Flows as the financing structure should not affect the firm value in theory and financing structures will change quite often. Only when valuing highly levered companies or assets such as insurance firms, banks or real estate properties, the levered free cash flow makes more sense to use since the whole rationale in those industries is about benefiting from leverage.
Step 2 – Projection of Future cash flows
As next step, we need to develop projections of our free cash flow forecast into the future. For this we need to determine projections normally for a minimum period of 5 years, in some cases (e.g. projects with an end date) even 10, 20, 30 or 50 years. The process for projection requires the following yearly estimations:
- Forecasting income statement (for EBIT) for the next five years using the growth rate.
- Projecting change in working capital and capital expenditures
- Depreciation and amortization are function of already existing assets and should also account for additional assets
A typical projection of unlevered free cash flows looks like this:
The important thing here is to project revenues bottom up by applying segment reporting basis and using different growth rate for each segments.
For EBIT, income statements shall be made and growth shall be used accordingly on sales. For other components of the free cash flows, balance sheets and cash flow statements are also to projected. A simple but less useful method is to calculate such components as % of sales and applying growth rate accordingly. At the end of the forecast period, we need to estimate a perpetuity growth factor to calculate the terminal value of the cash flows.
Step 3 – Calculating Discount Rate
The discount rate reflects the opportunity cost of capital, which is normally measured by the Weighted Average Cost of Capital (WACC). WACC is an important concept as when using IRR analysis, the WACC will be the hurdle rate, the required return an investment should achieve, otherwise the risk is higher than its benefits. In that case, cash flows are made equal to their present value and the net present value will be zero.
The popular ways to calculate Discount rate are :
- Weighted Average Cost of Capital (WACC): Applicable to discount the unlevered free cash flows (UFCF) Using a simple weighted average cost of capital (For UCFC)
WACC = (E/V )*CoE + (D/V)*CoD*(1-Tc)
Here we are multiplying the weight of equity in the capital structure (E/V) by the Cost of Equity(CoE) . The weight of debt in the capital structure (D/V) multiplied by the Cost of Debt(CoD) times 1 minus the Effective Tax Rate (Tc) which is the debt portion of the discount rate
- Cost of Equity (CoE): Applicable to discount the levered free cash flows (LFCF) or as the Cost of Equity used for in WACC. Cost of Equity mostly is estimated by using the Capital Asset Pricing Model (CAPM):
R = Rf + β(Rm – Rf)
R is Required Return/Discount Rate
Rf equals to the risk-free rate of an investment
Β equals stock’s beta
Rm equals overall stock market risk
Step 4 – Calculating Terminal Value
It is the value of the firm for years beyond the last projected year as the idea of business is based on going concern basis. There are many ways to calculate the terminal value. To keep it simple practitioners mostly use one of the two following methods to calculate the terminal value are
- Perpetual Growth Model: Here the assumption is the last growth rate will apply forever.
Terminal Value = [Last Projected FCF * (1 + Perpetual Growth Rate)] / [Discount Rate – Perpetual Growth Rate]
FCF means free cash flows, which can be either levered or unlevered, depending on which concept is being used.
- Exit Multiple Method: Here, terminal value of cash flows is a multiplier of income flows measure such as EBITDA which can be observed from select trading multiples in the same industry or from recent benchmark transactions. EBITDA is a profit measure before taking into account debt/equity costs, thus EBITDA only makes sense when compared to the Enterprise value (EV) and should only be used when using Unlevered Free Cash Flows.
Terminal Value = Exit EV/ EBITDA Multiple * Last Projected Year’s EBITDA
Step 5 – Discounting Cash Flows
In this last step, we should discount projected cash flows and terminal value to the present value. This is called Net Present Value (NPV) of future cash flows. The sum of the cash flows is equal to the value of the enterprise for unlevered free cash flows or equity value for the levered free cash flows.
Thus when using unlevered free cash flows and calculating the NPV (= Enterprise Value), one needs to deduct debt and add cash as per the valuation date.
Kindly refer to the example DCF Valuation Model.
A DCF model translates a business plan into a company valuation. The model captures all the key values drivers, which can be operational in nature but also model related such as the WACC, growth rate. Having a DCF model ready is very useful to explain the economics of a business and discuss its impact on the valuation.
The DCF Method is one of the theoretically most sound valuation concept since it bases on an income approach. Its also superior than using a capitalized earnings valuation when capitalizing net income which is an accounting measure but not a cash measure. Cash is more difficult to manipulate than accounting profits. For investors cash is king, thus the DCF method enjoys a high acceptance rate by many finance professionals.
Free cash flows are reliable measure of firm’s health that eliminates window dressing and subjective accounting policies. Hence, it can be said free cash flows are really the money available to the investors. So, DCF is more reliable financial valuation model.
DCF anaysis is best used when the business is already in existence for few years and forecast to some extend can be compared to historic performance. For Startups, a DCF model is more difficult to develop or even to read, since historical data is not available. As the entrepreneur of course will have a very optimistic view on his future, its more difficult to buy into this without real validation.
In practice, a DCF model is only as good as the quality and validation of the underlying financial projections (the business plan). As such any DCF model will be subjective and heavily depends on the plausibility of its argumentation. Hence the value of the same firm may result in a higher or lower valuation depending on how optimistic or conservative analyst’s projection are.