Discounted Cash Flow (DCF)
What is DCF?
Discounted Cash Flow (DCF) is an analysis method used to measure the present value of an investment, asset, or security. The DCF model provides us with the value an investor will reasonably pay for an investment considering their required ROI on that investment, known as the discount rate. This model adjusts expected future cash flows to the time value of money and accounts for variables such as the cost of capital to project a company’s future performance. Although we can use this valuation method for stocks, bonds, and other assets, today, we will focus on evaluating a company.
How is DCF Calculated?
The basic DCF calculation is:
DCF = (CF/(1+r)¹)+(CF/(1+r)²)+(CF/(1+r)³)+…+(CF/(1+r)^n)
- CF = Cash Flow for the Period
- r = Discount Rate (WACC)
- n = Period Number (Terminal Value)
Components of DCF
We need to further explore several components in the above calculation to understand how and why we use them.
- Cash Flow (CF): This term refers to the increase or decrease in the amount of money a business has in a given period. In DCF analysis, we typically use Unlevered Free Cash Flow (UFCF), also called Free Cash Flow to the Firm (FCFF). UFCF is the CF available to equity and debt-holders after expenditures in operations, capital, and investments. UFCF is used in the DCF model to remove capital structure’s impact on a company’s valuation, making companies more comparable. You can find this information in a company’s financial statements, but we calculate it as:
- UFCF = EBITDA — CAPEX — Working Capital — Taxes
- Discount Rate (WACC): When using DCF to value a company, the discount rate will be the Weighted Average Cost of Capital (WACC). WACC is the blended capital cost across all sources, such as preferred and common shares and debt. These costs are “weighted” as a percent of total capital and added together. Investors use WACC because it represents the required IRR that investors expect from the company. We calculate WACC as:
- WACC = (Cost of Equity * % of Equity) + (Cost of Debt * % of Debt) * (1 — Tax Rate) + (Cost of Preferred Stock * % of Preferred Stock)
- Period Number (Terminal Value): You’ll notice in our DCF formula that we must account for the cash flow in each Period, whether that be months, quarters, or years. When valuing a business, we typically look five periods out, but anything beyond that becomes murky to project. To account for this, we use the Terminal Value for periods beyond what we can reasonably project. There are two key ways we can determine the Terminal Value:
- Use an assume exit multiple where we sell the business.
- Use perpetual growth based on a reasonable, fixed growth rate.
This analysis uses much math and requires quite a bit of information about a company and industry. DCF is a very detailed, sensitive, and complex model. In our VC & PE Training program, we spend time walking our students through this analysis. If you’re interested in learning about joining, sign up for a free session to learn more.
Two additional components to the DCF model include Adjustment and Sensitivity Analysis. We want to make Adjustments for non-core assets and liabilities such as Net Debt, Pension Liabilities, or Operating Leases. Sensitivity Analysis includes testing changes for the Terminal Value and WACC.
DCF Example
This example uses the main formula above and does not include all CF, WACC, and Terminal Value calculations. We will be making assumptions for the sake of efficiency. To do an actual DCF deep dive, you will require an Excel document with quite a few inputs and formulas. I encourage you to do some Google searches.
Example: XYZ Company Valuation
- XYZ Company projects to have a UFCF of $100M for each of the next five Periods. WACC is 10% (our discount rate), and our Terminal Value is $300M.
- Based on the sum of our Cash Flows discounted for each Period, our DCF value for XYZ Company is $565M.
How would this model look in Excel? This screenshot below shows how data inputs into a spreadsheet would look (Not the same numbers).
There are a few resources where you can go to download a FREE Excel template for a DCF analysis. The one that seems to have the least strings attached (just signup for their newsletter, which you can later unsubscribe from) is here.
Pros vs. Cons of DCF
We can use several different valuation methods when analyzing a business investment, and DCF is a popular one. This analysis certainly provides the best “intrinsic” value of a business, is detailed, and includes all significant assumptions about the company. Also, it doesn’t require the use of comparable companies and allows for sensitivity analysis. Lastly, we can also calculate the expected Internal Rate of Return (IRR) on our investment. Some pitfalls of this method are that it is prone to errors and overcomplexity, and it requires a large number of assumptions. Terminal Value and WACC can be challenging to determine, and it only looks at the company’s value in isolation.
Final Thoughts
If you plan to work in finance in any capacity, the DCF model will be an essential tool in your toolkit. This method is complicated and takes a while to master, but it is very versatile in determining the value of many different types of investments.
This story is from Sutton Capital contributor Zeb Hastings. For more information on Zeb’s work, please visit his website.
Originally published at https://sutton.substack.com.
