# Discounted Cash Flow Model ## DCF Model – Calculating Discounted Cash Flows for Valuation Analysis A DCF Model today is one of the standard valuation methods used to derive the value of a company or an asset. Discounted Free Cash Flow analysis belongs to the income approach and therefore is one of the theoretically most sound valuation methods as the value depends on the expected income one can achieve with a business or an asset.

Building a Discounted Cash Flow (DCF) model is a very popular financial valuation method and widely used among professional investors to derive the value of a company and base their decision making on such analysis.

A DCF model is mostly built with a spreadsheet program such as MS Excel. It requires a projection of the company’s Free Cash Flows to Firm and then discounts them to their present values. Please see here for an Example DCF Valuation Model.

## How a DCF Model Works – The Basics

A DCF Model projects future cash flows and then discounts them with the company’s discount rate. The discounted cash flows are then summed up in the Net Present Value.

### Discounting the Cash Flows of the Forecast Period

To understand the principle of discounting, see below the illustration of a DCF model as an example:

In the above example, the cash flows are \$100 for the next 5 years.

The Discount Factor is calculated as per below formula, whereas r = Discount Rate and t = the year. Assuming that the discount rate is at 10%, thus, the value for r = .10 and t = year #. The Present value of the cash flow is then calculated as follows:  Using the figures in the table shown above, for year 1, the cash flow is \$100 which is then multiplied by the discount factor is 1/(1+0.1)^1 = 0.91, which leads to \$91 as the present value of the cash flows for the first year. The same process is then applied for the consecutive years but with the main difference that the discount factors become bigger and the present value of those cash flows are being reduced.

### The Calculation of Terminal Value

So far, we have described how to discount the cash flows up to year 5. But what about the cash flows after year 5?

The Terminal Value represents the value generated from all the expected cash flows after the forecast period which normally is 5 years. There are different ways to estimate the Terminal Value such as:

• Gordon Growth Model: 1 / (Discount rate – growth rate)
• Value Driver Models based on Economic Profit
• EBITDA Multiple

For our purposes, we keep it simple and use an EV/EBITDA multiple to estimate Terminal Value

Terminal Value calculates the combined future cash flows at the beginning of year 6, therefore it will be discounted by the end of year 5 discount factor which is the same as used for the last year. Terminal Value is then added to the other discounted cash flows to get the DCF Value of an asset or business.

The above example is just the most basic way of calculating the DCF value, assuming that the discount rate is at a constant discount rate of 10% in perpetuity.

DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + … + [CFn / (1+r)n]

Where:

CF = Cash Flow
n = year
r = discount rate (Weighted Average Cost of Capital)

The DCF formula is equal to the sum of annual cash flows which is then divided by one plus the discount rate (WACC) raised to the power of the time period. So we see that there are three elements needed to make the DCF model work:

• Time – Period of time used for the valuation (time period)
• Cash Flow – Accurate estimation of the annual cash flows (projected cash flows)
• Discount rate – the opportunity cost of capital which reflects the risk by estimating how much return you should make when investing in the same risky asset or business somewhere else per year. The discount rate can also be estimated by the Weighted Average Cost of Capital (WACC).

 https://en.wikipedia.org/wiki/Dividend_discount_model

 https://en.wikipedia.org/wiki/Weighted_average_cost_of_capital

## DCF Modeling – Step by Step

To further understand the calculation of each component in Discounted Cash Flow Valuation which is more complex, we have put a step by step guide together.

### Step 1 – Free Cash Flow Selection

Each DCF model is based on the projected Free Cash Flows. Free cash flows are the cash flows generated for the benefit of capital providers. There are two types of free cash flows:

• Free Cash Flow to Firm (FCFF) or also known as the Unlevered Free Cash Flows (UFCF): It is the cash flow available to the company without taking into account the effect of debt financing. The magic formula is:FCFF = EBIT(1-T) – CAPEX + Depreciation & Amortization – Change in Net Working Capital
• Free Cash Flows to Equity (FCFE) or the Levered Free Cash Flows: In this definition of cash flow we strictly look at the cash flows available to the Equity financing providers. This means they will benefit from any debt financing obtained.FCFE = FCFF + Change in Financial Debt – Interest Expenses + Tax Benefit due to Interest deductions

Kindly note,

• EBIT (Earnings before Interest and Taxes) is the operating profit generated by the company. Net Income is after tax and interest expenses and therefore changed by the company ’s financing structure, therefore we cannot use it.
• T stands for the effective expected tax rate. We basically subtract a pro-forma tax on EBIT by multiplying EBIT x (1-T) and without deducting interest as we want to have the taxes calculated before any effects of the financing structure.
• CAPEX stands for capital expenditures, which means investments in tangible and intangible assets. These are mostly significant cash expenses but as they are activated, they are not included in EBIT.
• Change in Net Working Capital is the change of accounts required to perform the business such as changes in receivables, inventory, and payables which affect the cash flow statement.
• Depreciation and Amortization (D&A) are added because they are non-cash expenses.

In most cases, business valuations use the Free Cash Flow to Firm 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.

Free Cash Flows to Equity subtracts all effects from debt as the focus of the analysis lies on the Equity investors. Hence the effect from debt service has to be included.

So make sure, before you start your DCF model, that you are clear which cash flows you are using as a basis for your DCF valuation.

### Step 2 – Analyzing Historic Financials for DCF Valuation

The first task before building a DCF model is to properly analyze a company’s or an asset’s historic financials. The analysis should cover at least three years in the past and should analyze the following in order to obtain a better understanding of the company or asset you like to value:

• Financial ratios related to liquidity, leverage, profitability, growth, etc.
• Historic cash flow statement and how the cash was being used
• Normalization of historic profits by looking which extraordinary one-time effect affected historic profits and come up with normalized figures for EBITDA and EBIT
• Identify the company’s key value drivers

Many times, people forget about the historic financials but its very relevant to better substantiate and validate your forecast of the business plan. Past data is not subject to estimations and therefore can be better trusted. Existing data is required to at least validate our assumptions going forward. Also, one should never do a DCF analysis without first analyzing the company’s historical financials in order to obtain a better understanding of the company and the industry it operates in.

### Step 3 – Projection of Future Free Cash Flows

As the next step, we need to develop projections of our free cash flow forecast into the future. There are two ways to do it:

• Direct Method: All required cash flow lines are forecasted directly. This is the quickest method but might be a bit less precise since we do not have all financial ratios at hand to better validate and substantiate our forecast.
• Three Statement Model: We forecast proper financial statements, Income Statement, Balance Sheet and Cash Flow Statement. This takes a bit longer but the benefit is that we will have a complete overview how the company will be performing or how many assets will be required from which we can calculate the Free Cash Flows to Firms.

Our forecast should normally cover a period of 5 years, in some cases (e.g. projects with an end date) even 10, 20, 30 or 50 years.

In our case, we build a three statement model.

To build the Income Statement we need in addition an operating model to derive each line of the income statement. This operating model is company specific and therefore we don’t go into this at this level. Building an operating model can be done in separate calculations and by separating the assumptions from the outputs. The important thing here is to project revenues bottom up by applying the segment reporting basis and using the appropriate assumptions for each segment.

Once we have built our three-statement model, we now can calculate the Free Cash Flows to Firm for the next 5 years and use this as a basis for our DCF. We now focus on the following:

• EBIT for the next five years
• Tax Rate estimation to apply a pro-forma tax on the company’s EBIT
• Add back depreciation & amortization (D&A)
• Summing up the changes in Net Working Capital (NWC) from the operating cash flow s available in the company’s cash flow statement
• CAPEX – the required investments for the years to come

A typical projection of unlevered free cash flows, therefore, looks like this: ### Step 4 – Calculating the Weighted Average Cost of Capital

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 on 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 Weighted Average Cost of Capital (WACC) is used to discount the Free Cash Flows to Firm (FCFF).

WACC = (E/V)*CoE + (D/V)*CoD*(1-Tc)

Here we are multiplying the weight of equity (E) 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) corresponds to the debt portion of the discount rate.

The Cost of Equity (CoE) is used to discount the Free Cash Flows to Equity (FCFE) or as the Cost of Equity required when calculating the WACC. Cost of Equity mostly is estimated by using the Capital Asset Pricing Model (CAPM):

R = Rf + β(Rm – Rf)

Where,

R is Required Return/Discount Rate
Rf is equal to the risk-free rate of an investment
Β equals stock’s beta
Rm equals overall stock market risk

### Step 5 – 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

1. 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.

2. 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

Important is to discount the Terminal Value with the applicable discount factor at end of year 5 (= beginning of year 6).

### Step 6 – Discounting Free Cash Flows

In this last step, we should discount the projected free cash flows and the terminal value to their present values. 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 the Free Cash Flows to Firm or equity value for the Free Cash Flows to Equity.

Therefore, 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. We also then want to check the implied valuation multiples (EV/EBITDA, P/E, P/B) our DCF valuation corresponds to. Kindly refer to the example DCF Valuation Model.

## Pros and Cons of Discounted Cash Flow Model

A DCF Model is indeed very useful but aside from its countless advantages, it also has its limitations or disadvantages.

• Income-based valuation technique which has a high explanatory power
• It captures the underlying fundamental drivers of a business such as the cost of equity, the weighted average cost of capital, growth rate, re-investment rate, etc.
• Since it relies on the Free Cash Flows, this eliminates the subjectivity in the reported earnings which means, the figures are realistic and precise.
• It allows key changes in the business plan to achieve better results.
• It predicts the best possible intrinsic value of the business.
• It ensures the preciseness of the business value or if it is realistic since one can refer the historical data and use it as a reference.
• It is easy to understand and apply as you conduct a valuation.
• The DCF method is very straightforward where the result gives you the value based on the expected cash flow a business or an asset can generate

• It demands a set of forward-looking assumptions which can be very subjective and prone to manipulation, thus, every model will vary depending on who made the model.
• It is extremely sensitive to assumptions related to the perpetual growth rate and discount rate which are key drivers in determining the present value of the cash flows.
• It only works best if the business plan is guaranteed to work and if the future free cash flows are accurate, otherwise, the model will be prone to errors and uncertainty. Thus, making the model faulty and not useful.
• The expected terminal value usually comprises too much of the total value which is often around 65-75%.
• Any minor changes in the assumptions provided on the terminal year will greatly impact the final valuation.
• It needs constant vigilance and modification to ensure that the model is as accurate as possible.
• It is not suited for short-term investment and better for long-term investments with proper historical data recorded.

Despite its pros and cons, as long as the DCF model is done correctly with solid inputs and a working business plan, the resulting DCF model will be one of the best tools to value an investment, project, asset, business, etc.

## Conclusion

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 concepts since it bases on an income approach. It’s also superior to 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 a reliable measure of a 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, a Discounted Cash Flow model – when used correctly – is quite a reliable valuation method.

DCF analysis is best used when the business is already in existence for a few years and forecast to some extent can be compared to historical performance. For Startups, a DCF model is more difficult to develop or even to read, since historical data is not available. As the entrepreneur, in many cases, will have a very optimistic view on his future, it’s 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 dependent 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 the analyst’s projection are.

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