Discounted Cash Flow (DCF)

Concept

Discounted Cash Flow (DCF) is a valuation technique used to determine the present value of a series of future cash flows. The idea behind DCF is that money available now is worth more than the same amount in the future due to its potential earning capacity (i.e., the Time Value of Money). By discounting future cash flows back to their present value, investors and analysts gain insight into how much they should pay today for a series of expected future earnings.

DCF is widely used for:

• Company and asset valuation
• Capital budgeting and project appraisals
• Investment decisions and strategic planning

The methodology generally uses the Weighted Average Cost of Capital (WACC) as the discount rate when valuing the entire firm (i.e., enterprise value), but can also employ alternative discount rates (e.g., cost of equity for equity valuation).

Formula

A typical DCF model can be summarized with the following formula for the enterprise value (EV):

$$EV = \sum_{t=1}^{n} \frac{FCF_t}{(1 + \text{WACC})^t} + \frac{\text{Terminal Value}}{(1 + \text{WACC})^n}$$

Where:

• $FCF_t$ is the free cash flow (to the firm) at time $t$.
• $\text{WACC}$ is the discount rate that reflects the required return on the firm’s entire capital structure.
• $n$ is the number of years in the forecast period.
• Terminal Value (TV) represents the value of the company’s cash flows beyond the forecast horizon. Common methods for estimating TV include:
  • Perpetuity Growth Method: $$TV = \frac{FCF_{n+1}}{(\text{WACC} - g)}$$ Where $g$ is the perpetual growth rate of the free cash flow.
  • Exit Multiple Method: $$TV = \text{EBITDA}_{n} \times \text{Exit Multiple}$$ Where $\text{EBITDA}_{n}$ is the last projected EBITDA and $\text{Exit Multiple}$ is a comparable valuation multiple.

Steps to Perform a DCF Analysis

1. Forecast Free Cash Flows
   Project the firm’s annual free cash flows over a certain number of years ($n$). For a refresher, see Free Cash Flow (FCF) concepts.

2. Estimate a Discount Rate
   Use a suitable discount rate to reflect the time value of money and the risk of the investment:

   • WACC if valuing the entire firm (enterprise value).
   • Cost of equity if focusing on equity valuation (often referred to as discounted dividends or FCFE valuation).

3. Calculate the Terminal Value (TV)
   Determine the company’s value after the projection period. A common approach is the perpetuity growth method, assuming a stable long-term growth rate.

4. Discount Cash Flows & Terminal Value
   Convert all future cash flows and the terminal value to present value by discounting them using the chosen discount rate.

5. Sum Present Values
   Add the discounted cash flows and the discounted terminal value to arrive at the enterprise value (EV).

   • For equity value, adjust by subtracting net debt (i.e., total debt minus cash and equivalents).

6. Make an Investment Decision
   Compare this result to the current market value or to your target price. If the DCF-based valuation is higher than the market price, the investment might be considered undervalued (and vice versa).

Example Calculation

Suppose you forecast the following free cash flows (to the firm) and assume a three-year projection:

• $FCF_1$ = $100
• $FCF_2$ = $120
• $FCF_3$ = $140
• Discount Rate ($\text{WACC}$) = 10%
• Long-Term Growth Rate ($g$) = 2%

1. Calculate Terminal Value
Using the perpetuity growth method at the end of Year 3:

$$\begin{aligned} TV &= \frac{FCF_3 \times (1 + g)}{WACC - g} = \frac{140 \times (1 + 0.02)}{0.10 - 0.02} \\ &= \frac{140 \times 1.02}{0.08} = \frac{142.8}{0.08} = 1{,}785 \end{aligned}$$

2. Discount Each Cash Flow

$$PV(FCF_1) = \frac{100}{(1.10)^1} = 90.9$$ $$PV(FCF_2) = \frac{120}{(1.10)^2} \approx 99.2$$ $$PV(FCF_3) = \frac{140}{(1.10)^3} \approx 105$$ $$PV(TV) = \frac{1{,}785}{(1.10)^3} \approx 1{,}338.4$$

3. Sum All Present Values

$$\begin{aligned} \text{Enterprise Value (EV)} &= 90.9 + 99.2 + 105 + 1{,}338.4 \\ &\approx 1{,}633.5 \end{aligned}$$

Hence, the approximate enterprise value is $1,634. To derive equity value, you would typically subtract net debt (total debt minus cash) from this enterprise value.

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Takeaway

DCF analysis is a cornerstone of modern valuation, helping you understand the intrinsic value of a company or project. By projecting future free cash flows and discounting them to the present, investors and managers can compare that value to the market price or investment cost and decide whether an opportunity is attractive. While powerful, DCF models are highly sensitive to assumptions about growth rates, discount rates, and terminal value—so careful consideration and scenario analysis are vital.