DCF modelling is a financial estimation tool, which is used to calculate the intrinsic value of an investment by forecasting cash flows in the future.
It helps to figure out the intrinsic value of a company based on the free cash flow that it calculates, discounted at a given discount rate that would be the company’s weighted average cost of capital, or WACC.
It is an estimate of what value the firm is likely to hold going into the future if it could realistically keep generating expected cash flows over the time. The outcome is referred to as the Net Present Value or NPV.
DCF modelling assists investors to determine whether an investment is worthwhile by comparing the intrinsic value derived from cash flow projections with the investment’s current market value.
For instance, if the DCF valuation indicates that the intrinsic value of a company’s stock is higher than its market price then it can be undervalued and one should buy it.
The advantage of DCF over market-based valuations is that the valuation relies on cash flow generation by the company rather than on the sentiment of the market or demand for the stock.
Some of the primary benefits of DCF is to take account of time value of money, where a dollar today is more valuable than the same amount of dollars at another date.
However, one of its main drawbacks remains the reliance on assumptions that deal with the projection of future cash flows and discount rates that may often prove inaccurate if projections are overly optimistic or lack accuracy.
However, DCF is still a core investment valuation resource to investors because it enables them to make wise decisions concerning the acquisition of the security, purchase, and capital investment by relating market price with future performance.
Importance of DCF modeling
Intrinsic Value Estimation. The DCF model calculates the intrinsic value of an asset, which would allow investors to value it based on whether it is under- or overvalued compared to the current market price.
Decision-making tool: Through a DCF model, companies and investors can thus make data-driven decisions in acquisitions, mergers, investments, and any form of financial transactions.
Project Feasibility: DCF modelling also helps one determine the feasibility of projects by projecting their future cash flows and comparing them with the investment requirements at the beginning.
The Core Principle of DCF: The Time Value of Money
The time value of money (TVM) is basically a concept in finance where a dollar today is more valuable than a dollar tomorrow. The DCF model accounts for this principle when discounting the future cash flows into its present value-that afterwards it adjusts for inflation, opportunity cost, and all the risk factors cash flows will eventually be subjected to in the future.
Key Components of DCF Modelling
a) Cash Flow Projections
Cash flow projections are estimates of the cash flows a company or a project can be expected to generate into the future. Such projections are typically done for 5-10 years, depending on the asset and the industry. Good cash flow projections are essential when making a meaningful valuation.
b) Discount Rate
The discount rate represents the opportunity cost, risk, and inflation faced in an investment. It brings the future cash flows to present value. The discount rate choice is quite important since it determines the overall outcome of a DCF model.
c) Terminal Value
Since the projection of cash flows cannot be done indefinitely, a terminal value is estimated to pick up the value of cash flow beyond an explicit forecast period. In this sense, the terminal value represents the model assumption regarding the perpetuity of the asset’s value or at a point of sale.
Understanding Free cash flow (FCF)
Free cash flow or FCF measures how well the companies are performing in terms of cash flows. It simply represents the cash available after covering all operating and CAPEX expenses.
Therefore, FCF demonstrates the liquidity available for growth, paying dividends, or even paying down debt. It filters less than earnings because it is real cash compared with earnings that have accounting practices, non-cash items, and manipulation.
FCF in DCF Modelling is crucial because it forms the basis with which intrinsic value for a company can be estimated.
The DCF model typically provides a projection of future FCFs, thereby establishing an effective way to discount them back to present value in determining whether a firm is undervalued or overvalued.
Compared to net income and earnings, DCF analysis centers on FCF so that the company’s potential to generate cash for shareholders is captured with a richer valuation even in conditions of volatile markets.
FCF does not count as part of earnings is non-cash expenses, like depreciation and amortization. Earnings may be skewed by different accounting methods; therefore, it should not be an authentic representation of the cash position.
FCF depicts net cash flows and therefore comes closer to the pure performance of a company’s operating activities, along with its ability to return value back to investors.
For an investor, FCF is an actionable metric in the sense that it clearly evaluates a company’s power and stability.
The formula used to calculate FCF
FCF = Operating cash – Capital expenditure
Determining the Discount Rate: WACC and Alternatives
In Discounted Cash Flow (DCF) modelling, the discount rate is the rate used to convert future cash flows into today’s value.
This rate reflects the risk of the investment and the opportunity cost of putting money elsewhere. The discount rate can be calculated by using the Weighted Average Cost of Capital (WACC).
Using WACC as a method
WACC is the average rate at which a firm would pay for its debt and equity, weighted by how much each constitutes in its capital structure.
It is like the “average” rate a company has to pay to fund its operations and investments, considering both borrowed money (debt) and money from shareholders (equity).
The formula for WACC
Where,
E=Market value of the firm’s equity
D=Market value of the firm’s debt
V=E+D
Re=Cost of equity
Rd=Cost of debt
Tc=Corporate tax rate
WACC is actually a simplification of equity and debt costs which have the proportion of each balanced out.
Alternatives to WACC
In some cases, you would apply a different discount rate. For example,
You would use the Cost of Equity (with the Capital Asset Pricing Model, or CAPM) if you only cared about what shareholders required as return.
The APV approach adds tax benefits that arise due to debt to equity value separately.
Selecting the right discounting rate is important as it hugely affects the valuation for a DCF model.
Calculating the Terminal Value
In Discounted Cash Flow (DCF) modelling, the terminal value estimates the value of a business beyond the forecasted cash flow period, capturing long-term cash flows that are impractical to project individually.
The terminal value is quite important as it usually accounts for more than 50% of the overall valuation of an entire business in a DCF model for established companies that have stable cash flows.
Adding the terminal value in the DCF model, it is able to encompass and provide more accurate valuations of a company’s worth by projecting not just short-term elements but also long-term business potential.
Terminal value can be calculated using two models:
1. Perpetuity Growth Model
The assumption is that business will grow at a constant rate perpetually. It suits stable companies that are mature and expected to grow slowly in the long run Formula for this model as given below:
Where,
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TV = terminal value
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FCF = free cash flow
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n = year 1 of terminal period or final year
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g = perpetual growth rate of FCF
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WACC = Weighted Average Cost of Capital
2. Exit Multiple Model
In this method, a multiple is applied to the cash flow or earnings of the last forecasted year, based on industry standards or comparable companies. It’s mostly used in private equity or high-growth industries where lesser confidence exists with regards to stability for long-term growth.
Advantages and Limitations of DCF Modeling
Advantages
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Intrinsic Valuation: It provides theoretically sound value based on future cash flows.
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It relates to all aspects of the company and market.
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It is flexible: it can be adjusted to varied assumptions about growth and risk.
Limitations
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Assumption Sensitivity: DCF results are very sensitive to assumptions on growth rate and discount rate.
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Complexity: Requires thorough projections and an understanding of the financial metrics.
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This is difficult to use for high-growth organizations because cash flows are usually uncertain for early-stage ventures.
Applications of DCF Modeling
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A valuation of a firm: DCF is used by investors to come up with the intrinsic value of a company when deciding whether to buy or sell stocks.
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Project Evaluation: Companies often utilize DCF in the evaluation of long-term investment or capital projects.
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M&A Transactions: DCF is probably the most critical model adopted in the calculation of a target company’s value in mergers and acquisitions.
Conclusion
The discounted cash flow, or DCF, model is an extremely powerful financial tool for valuation of assets and in making considered investment decisions.
Estimating the intrinsic value of an asset based on future cash flows provides significant insight regarding potential investment returns.
Being sensitive to assumptions, its application is limited, but a well-constructed DCF model becomes invaluable in finance and investment analysis.
DCF modelling is not really that easy to understand but it is one skill everyone involved in financial analysis, investment banking, or corporate finance must master.