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Discounted Cash Flow Valuation Model (DCF Model)
Discounted cash flow (DCF) is a commonly used valuation method which is used to estimate the value of a business or an asset based on its future cash flows. By creating a discounted cash flow valuation model, you will see how attractive the investment opportunity is since it focuses on cash and not on accounting profits, thus, it considers any factors that might create an impact regarding the cash position of a business or the asset. This clearly shows why the discounted cash flow valuation model is highly regarded as most solid valuation methods to value a business or an asset.
- Captures the underlying fundamental drivers of a business (e.g. cost of equity, weighted average cost of capital, growth rate, re-investment rate, etc.)
- Relies on Free Cash Flows which eliminates subjectivity in the reported earnings
- Allows key changes in the business plan
- Predicts the best possible intrinsic value
- Checks if the business is over-valued or under-valued
- Simple to understand and apply
- Resulting value is straightforward; positive = good investment , negative = bad investment
- Demands a set of forward-looking assumptions which are subjective
- Extremely sensitive to assumptions related to the perpetual growth rate and discount rate
- Only works best is the business plan will work and the future free cash flows are accurate, otherwise, the model will be susceptible to errors and uncertainty
- Terminal value comprises too much of the total value (65-75%)
- Minor variations in the assumptions on the terminal year will greatly impact the final valuation
- Needs constant vigilance and modification
- Not suited for short-term investment
Despite the advantages and its disadvantages, as long as the DCF model is done correctly with solid inputs and business plan, the resulting DCF model will lead to the best tool to value an investment.
How to Calculate the DCF Value
So, you plan to save money and start venturing opportunities for your future but don’t know how to ensure that you will make smart decisions? While there will always be an element of risk when it comes to investments, you can make more informed choices with some simple statistical techniques and tools to evaluate opportunities and get the most value out of it. By simply conducting a DCF analysis or creating a DCF model, you will be able to determine how attractive an investment opportunity is.
The DCF Model analyzes the future cash flows and then discounts them with the required annual rate to determine the present estimated value of an investment. The resulting value is then used to evaluate if the investment is potentially profitable and feasible.
There are three elements that you need to calculate the DCF value:
- Period of time used for the valuation (time period)
- Accurate estimation of the annual cash flows (projected cash flows)
- Amount of money that could be earned if invested to something of equivalent risk (WACC or discount rate)
After realizing the elements that you needed to calculate the DCF value, next would be to apply it to the DCF formula. 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.
DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + ... + [CFn / (1+r)n]
CF = Cash Flow
n = year
r= discount rate (Weighted Average Cost of Capital)
The discount rate is typically the weighted average cost of capital of a business or an asset since it represents the required expected rate of returns for the investors. Here are some of the variables that needed to be discounted when assessing the annual cash flow or basically what counts to be as the WACC of a business or an asset:
- Net income after tax
- Working capital
- Capital expenditures
To further understand how it is calculated, see below illustration as an example.
The DCF formula is applicable not only for valuing a business or an asset, but it can also be used in cases such as valuing the entire business as a whole or separately, valuing a project or investment, valuing a bond or shares in a company, valuing a commercial property, etc.
An Example of How the DCF Model Works – DCF Model Templates
To make the process of building a DCF Model easier, using discounted cash flow model templates is the answer. The DCF model templates will serve as the basis and the foundation of your model so you don’t have to spend a lot of time on creating from scratch. You also don’t have to spend a high amount of fees to ask a professional to build a completely new DCF model for you. If you are looking to acquire discounted cash flow model templates, you can check out our list above and choose which DCF model templates you need. You might be wondering, how does the DCF model work?
The DCF model templates are usually in Excel and require at least a minimum of 5 years of Cash Flow stream. Since the DCF model is normally done by forecasting the financial statements of a business, the templates are also included with the three statement model which you can then calculate the Cash Flow to Firm over the next years by adding up the following:
- Earnings before Interest and Taxes (EBIT)
- Adjusted Taxes which is the applicable income tax rate applied to EBIT
- Non-cash expenses are added back e.g. Depreciation and Amortization
- Adjustment for changes in Net Working Capital
- Deduction of CAPEX
After realizing the factors above, a discount rate is then calculated to discount the future cash flows to its present value. The discount rate or the Weighted Average Cost of Capital (WACC) should reflect the business’ or an asset’s risks. After calculating the discount rate, it will then be applied to the free cash flows to firm to get the present value which should be equal to the Enterprise Value. To arrive at the final Equity Value, the net debt (business’ financial debt) is deducted and then the business’ cash is added. The equity value will be the end result of the DCF valuation model.
Feel free to check out our discounted cash flow model templates to use as a starting point to start building your very own DCF model. No more wasting time building from the beginning. Just simply input and replace the line items with more detailed calculations referring to your business’ financial specifications. The DCF model template should work as long as the figures you inputted are correctly flowing in the to Free Cash Flow to Firm!