There are many tried and tested approaches to establishing the intrinsic value of a company or an investment based on its expected performance in the future, but the best tool investors have is the Discounted Cash Flow (DCF) model.
It is widely used by investors, analysts, and professionals in the finance sector to determine if an asset or a company is overvalued or undervalued. However, building this model from scratch can be challenging.
I will guide you on how to create a DCF model in simple terms. Even if you are not familiar with finance, we can break it down step by step during the presentation, and you will understand what this tool does and how to use it.
What is a DCF model?
The DCF model is a method of calculating the value of a company today based on its future cash flows. Simply put, it assumes that money in the future is worth less than money today due to factors like inflation, risk, and the inability to use that money for other purposes now. The DCF model adjusts future earnings to present value terms.
Estimate Free Cash Flows (FCF)
The core of a DCF model is the company’s free cash flow – the cash generated after covering operating expenses and capital expenditures. It is the remaining money available for investors and is crucial in the DCF model’s evaluation.
How you forecast it:
Estimate Revenue Growth: Predict the company’s revenue for the upcoming years. This estimation can be based on historical growth rates, industry expectations, or management guidance. Typically, revenue is projected for 5 to 10 years.
Calculate Operating Expenses and EBIT: Net off all the operating expenses, whether salary expense, rental, or cost of goods sold. That is Earnings before Interest and Taxes, or EBIT. This is how much money the company generates from its core operations before it pays any interest or taxes.
Taxes: Deduct the taxes paid. Applying this, we get the Net Operating Profit after Taxes, or NOPAT. The NOPAT is what the firm gets to keep after the government has taken its share.
Lower Capital Expenditures (CapEx): This represents the cash the business requires reinvested to sustain or expand itself – that is, new machinery, new buildings, new technology, etc. Cash here is being used and not available for distribution to investors.
Adjust for the Changes in Working Capital: It is the amount a company requires to operate on a day-to-day basis. The change in working capital related to items like inventory and accounts payable will impact cash flow, and therefore FCF shall be adjusted as well.
Determine a Discount Rate
Having projected the company’s cash flows into the future, you next discount them back to a present value. You observe that money in the future is worth less than money currently available. But what discount rate do you use?
Most DCF models apply the WACC of the firm as a discount rate. WACC represents the average rate at which all forms of debt and equity expect the company to earn. It assumes that the firm finances its operations using both debt and equity.
WACC Formula can be presented in a simplified mathematical form as follows:
WACC= [E / V] × Cost of Equity + [D / V] × Cost of Debt × (1 – Tax Rate)
E = market value of equity
D = market value of debt
V = total value, or sum of debt and equity
Cost of Equity is generally determined by reference to CAPM. This takes the risk of investing in the company compared to the risk associated with the general market.
Calculation of Terminal Value
Since the cash flows of the company cannot be projected into infinity, we make use of a shortcut known as terminal value in order to estimate and approximate the value of the company beyond our forecast period, and this forecast period is at least 5-10 years. It therefore represents all cash flows remaining from that point into infinity.
There are two primary methods of calculating terminal value.
1. Perpetual Growth Method This considers that the cash flow of the company will continue to grow infinitely. A relatively low growth rate, in the form of long-term GDP or inflation rate, is applied.
Terminal Value =
Last Year FCF × (1 + Growth Rate)
WACC – Growth Rate \
2. Exit Multiple Method It is a method in which a multiple-like an EBITDA multiple-driven by comparable companies in the same industry, is applied.
Discounting Cash Flows to Present Value
You take all the cash flows and the terminal value and bring them back to the present using the discount rate, WACC. Thus, you have a PV for every cash flow in every single year.
Discounting each year’s cash flow by the discount rate is described as follows:
PV of FCF = FCF/(1 + WACC)^n
Calculating Equity Value
Subtract net debt – total debt, minus cash – from enterprise value to find out how much the company is worth to shareholders. This will be equity value.
Equity Value = Enterprise Value – Net Debt
Equity value is what amount, according to the DCF model, the company’s shares are worth today. You compare this value to how highly the company is priced in the market right now, as found by taking its current market capitalization.
Sensitivity Analysis
Lastly, a sensitivity analysis must be done to see the effects of changes in assumptions, especially on the most important assumptions such as revenue growth, WACC or terminal growth rate, on the valuation. This would therefore make you see the kind of uncertainty that bases the valuation and risks that are attached.
Conclusion
Building a Discounted Cash Flow model looks pretty intimidating at first, but breaking it down to such manageable steps really makes a lot clearer. You’re just trying to forecast how much cash the business will generate, discount that back to what it’s worth today and then an intelligent decision as to whether you want to invest in it or not.
Although the DCF model has its weaknesses-mostly because it rests on many assumptions-it is nevertheless a very potent tool in that it’ll better help you realize what the underlying value is for some company or asset when used responsibly.