This article is an add-on to our previous article on the Capitalized Cash Flow (CCF) approach. Another income approach is the Discounted Cash Flow (DCF) approach. People who do not work in finance are likely unfamiliar with the term DCF. This method is widely used to determine the value of businesses and is especially applicable for start-up companies that are experiencing high growth, or companies who face significant volatility and uncertainty with respect to their current and future expected earnings. In this article, we will break down the DCF methodology in a simple and easy-to-understand way.
What is Discounted Cash Flow?
The DCF method is a valuation technique that is employed to determine the present value of an investment or project based on its expected future cash flows. Given that money today holds more value than the same amount in the future due to inflation and opportunity costs, the DCF methodology applies a discount rate to adjust future earnings to account for these considerations.
The Time Value of Money Concept
A key component in the foundation of a DCF is tied to the concept of the “time value of money” (TVM). TVM recognizes that all else equal, a dollar today is worth more than one dollar in the future (i.e. 25 years from now) due to several factors, including but not limited to inflation. Overtime, inflation erodes the purchasing power of money, making a dollar in the future, less valuable than a dollar today.
Steps in the DCF Calculation
1. Estimate Future Expected Cash Flows
- Identify the cash inflows and cash outflows expected to be generated and incurred, respectively by the asset (i.e. Company) over its lifetime.
- Cash flows are typically forecasted over several years up to a point in time that it reaches a mature state with general consistency in earnings and overall growth achieved is commensurate with mature companies (2% to 3% generally speaking).
2. Choose a Discount Rate
- The discount rate represents the required return on investment.
- What most CBV’s use is what is referred to as the Weighted Average Cost of Capital (WACC) – which represents the overall return investors and lenders of money in the company would require to earn for taking on the risk of investing in the subject company or lending to it, in lieu of other risk-free investment opportunities.
3. Calculate the Present Value (PV) of the Future Expected Cash Flows
- Future cash flows of the subject company are discounted back to the present using the formula:
Where: PV = CF / (1+r)t
- PV = Present Value
- CF = Future Expect Cash Flow,
- Where:
- CF = EBITDA – Income tax – capital expenditures – working capital requirements;
- EBITDA = Earnings before interest, taxes, depreciation and amortization
- Where:
- r = Discount Rate
- t = Number of years in the future
4. Sum the Present Values
- Add up the present values of all projected cash flows.
5. Determine the Terminal Value
- Since cash flows may continue indefinitely, a terminal value (TV) is often added at the end of the projection period using the formula
TV = CF final :/ (r – g); often referred to as the Gordon Growth Model
Where:
- g = Growth rate of cash flows beyond the projection period.
6. Compute the Total Value
- The sum of the present value of projected cash flows and terminal value provides the value of the business’ operations.
Strengths and Limitations of DCF
Strengths:
- Widely held as the best valuation methodology for volatile and start-up companies
- Provides an objective and quantitative approach to decision-making
- Considers costs and benefits over time
Limitations:
- Heavily dependent on assumptions and requires accurate financial forecasting, which can be uncertain for certain companies, industries and economic climates
- Most small to medium sized businesses don’t have available forecasts which can be problematic in litigation settings where there is a historical valuation date and the valuator can not rely on hindsight
- Small changes in assumptions can significantly impact results
Conclusion
The DCF is a valuable tool for determining the value of a business. While it requires careful consideration of assumptions, DCF remains an essential methodology in both finance and business valuations.
