Building a Discounted Cash Flow: A Comprehensive Guide

Discounted Cash Flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity.

Here’s a detailed step-by-step guide to building a DCF model:

Step 1: Project Future Cash Flows

The first step in a DCF analysis is to project the company’s free cash flows. Free cash flow is the cash that a company generates from its operations that is free to be distributed to all capital providers. It can be calculated as EBIT*(1-Tax Rate) + Depreciation & Amortization - Changes in Working Capital - Capital Expenditure.

When projecting future cash flows, consider factors such as historical trends, growth rates, and economic outlook. Also, consider the company’s competitive position and potential changes in the industry.

Step 2: Determine the Discount Rate

The discount rate is the rate of return required by an investor to invest in the business. It is often estimated using the Weighted Average Cost of Capital (WACC). The WACC takes into account the cost of equity and the cost of debt, and weights them according to the proportion of equity and debt in the company’s capital structure.

Step 3: Discount the Cash Flows

Once we have the projected cash flows and the discount rate, we can calculate the present value of the cash flows. The present value is calculated by dividing the cash flow for each period by (1 + discount rate) raised to the power of the period number. This step transforms future cash flows into today’s dollars, which allows for a fair comparison of cash flows from different periods.

Step 4: Calculate the Terminal Value

The terminal value represents the value of the company after the forecast period. It is calculated using the Gordon Growth Model or the Exit Multiple Method. The Gordon Growth Model assumes that free cash flows will grow at a constant rate indefinitely, while the Exit Multiple Method assumes that the business will be sold for a multiple of some account measure.

Step 5: Discount the Terminal Value

The terminal value is discounted back to the present value using the same discount rate used in Step 3. This gives us the present value of the terminal value.

Step 6: Sum Up the Present Values

The final step is to add up the present values of the cash flows and the discounted terminal value. This gives us the total DCF value of the company.

A DCF analysis can be complex and requires making many assumptions. However, it is a powerful tool in the financial analyst’s toolbox. With careful application, it can yield valuable insights into a company’s financial health and future prospects.