Company Valuation: Basics of discounted cash flow (DCF) analysis

A discounted cash flow (DCF) model used to value a business

​Valuing a company using the Discounted Cash Flow (DCF) method involves several steps. The DCF method estimates the value of a business or investment based on its expected future cash flows (i.e. the money expected to be generated by the investment), which are discounted back to their present value using a discount rate. Here’s a detailed guide on how to conduct a DCF valuation

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​Step 1: Project Free Cash Flows (FCFs)

FCF = NetOperatingProfitafterTaxes + Depreciation and Amortization− Changes in Working Capital − Capital Expenditures

Forecast Revenue
​Estimate the company’s revenue growth over a forecast period (typically 5-10 years).
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Estimate Operating Costs and Taxes:
Subtract operating expenses and taxes from the projected revenues to obtain net operating profit after tax (NOPAT).

Estimate Changes in Working Capital
Estimate Capital Expenditures
​Calculate Free Cash Flow

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​Step 2: Determine the Discount Rate

Cost of Equity
Use the Capital Asset Pricing Model (CAPM) to calculate the cost of equity:
Cost of Equity = Risk-Free Rate+β×(Market Return−Risk-Free Rate)

Cost of Debt
Estimate the cost of debt by looking at the company’s interest expense and the average interest rate on its debt.

Weighted Average Cost of Capital (WACC):
Calculate WACC, which is the discount rate used in the DCF model.
WACC=[(E/(E+D)) × Cost of Equity] + [(D/(E+D))×Cost of Debt×(1−Tax Rate)]
Where E is the market value of equity and D is the market value of debt.

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​Step 3: Calculate the Terminal Value

Perpetual Growth method
​Terminal Value= FCF_n+1/(WACC−g) ​
 
Where FCF_n+1 is the free cash flow in the year following the last projected year, and g is the perpetual growth rate of the FCF.

Exit Multiple method
Terminal value = EBITDA * Exit multiple
e.g. Terminal value = EBITDA in final year x 7.0
EBITDA refers to 'earnings before interest, taxes, depreciation and amortization.
EBITDA multiples typically vary from 5 - 12  depending on the characteristics of the investment.

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​Step 4: Discount the Cash Flows

​Present Value of Free Cash Flows
Discount the projected free cash flows and terminal value back to their present value using WACC.
PV of FCFs =∑𝑡=FCF_𝑡/(1+WACC)^𝑡

Where 𝑡 is the year in the projection period.

Present Value of Terminal Value:
Discount the terminal value back to its present value:
PV of Terminal Value=Terminal Value/(1+WACC)^𝑛
where n is the end-of-year at which the investment is expected to be sold.

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​Step 5: Calculate the Enterprise Value and Equity Value

Enterprise Value (EV)
Sum the present value of the free cash flows and the present value of the terminal value
Enterprise Value= PV of FCFs + PV of Terminal Value

Equity Value
Subtract net debt (total debt minus cash and cash equivalents) from the enterprise value:
Equity Value = Enterprise Value − Net Debt

where Net Debt = Total Debt - cash

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Example

Let’s assume a company has the following projected free cash flows for the next 5 years:

Year 1: $100 million
Year 2: $120 million
Year 3: $140 million
Year 4: $160 million
Year 5: $180 million
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Assume the terminal growth rate is 3%, and the WACC is 10%. The FCF for Year 6 (used for terminal value calculation) is $185.4 million (assuming a growth rate of 3% from Year 5).

Terminal Value
Terminal Value= 185.4/(0.10−0.03) =2,648.57 million

Present Value of FCFs:
PV of FCFs=100(1+0.10)^1+120(1+0.10)^2+140(1+0.10)^3+160(1+0.10)^4+180(1+0.10)^5

PV of FCFs=90.91+99.17+105.18+109.28+111.77=516.31 million

Present Value of Terminal Value
PV of Terminal Value=2,648.57(1+0.10)^5=1,644.55 million

Enterprise Value
Enterprise Value=516.31+1,644.55=2,160.87 million

If the company has $500 million in net debt:
Equity Value=2,160.87−500=1,660.87 million

Calculations for the discounted cash flow (DCF) model used to value the business in the example given.

​By following these steps, you can estimate the intrinsic value of a company using the DCF method, which provides a comprehensive assessment of its financial future and helps in making informed investment decisions.