Discounted Cash Flow Technique: An Overview

DCF or Discounted Cash Flow is a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. The opportunity is considered as good one, if the value arrived at through DCF analysis is higher than the current cost of the investment.
The purpose of DCF analysis is just to estimate the money you’d receive from an investment and to adjust for the time value of money.
DCF technique do involves complex math and financial modelling, but if you understand the basic concepts behind DCF, you can perform the calculations to help you make investment decisions or value small businesses.
DCF Valuation is used by approximately all cases of investments and corporate actions like equity investment, merger & acquisition (M&A), IPO valuation, follow-on offering, credit analysis.
The 4-Step DCF valuation technique
Step 1 — Forecast Expected Cash Flow: the first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company’s revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement. We describe these variables and how to estimate them in other screens.
Step 2 — Estimate the Discount Rate: the next order of business is to estimate the company’s weighted average cost of capital (WACC), which is the discount rate that’s used in the valuation process. We describe how to do this using easily observable inputs in other screens.
Step 3 — Calculate the Value of the Corporation: the company’s WACC is then used to discount the expected cash flows during the Excess Return Period to get the corporation’s Cash Flow from Operations. We also use the WACC to calculate the company’s Residual Value. To that we add the value of Short-Term Assets on hand to get the Corporate Value.
Step 4 — Calculate Intrinsic Stock Value: we then subtract the values of the company’s liabilities — debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value.
The 4-Step DCF valuation technique
Step 1 — Forecast Expected Cash Flow: The first order of business is to forecast the expected cash flow for the company based on assumptions regarding the company’s revenue growth rate, net operating profit margin, income tax rate, fixed investment requirement, and incremental working capital requirement. We describe these variables and how to estimate them in other screens.
Step 2 — Estimate the Discount Rate: The next order of business is to estimate the company’s weighted average cost of capital (WACC), which is the discount rate that’s used in the valuation process. We describe how to do this using easily observable inputs in other screens.
Step 3 — Calculate the Value of the Corporation: The company’s WACC is then used to discount the expected cash flows during the excess return period to get the corporation’s Cash Flow from Operations. We also use the WACC to calculate the company’s Residual Value. To that we add the value of Short-Term Assets on hand to get the Corporate Value.
Step 4 — Calculate Intrinsic Stock Value: We then subtract the values of the company’s liabilities — debt, preferred stock, and other short-term liabilities to get Value to Common Equity, divide that amount by the amount of stock outstanding to get the per share intrinsic stock value.
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