What is Discounted Cash Flow Valuation?
Discounted cash flow analysis is method of analyzing the present value of company or investment or cash flow by adjusting future cash flows to the time value of money where this analysis assesses the present fair value of assets or projects/company by taking into effect many factors like inflation, risk and cost of capital and analyze the company’s performance in future.
In other words, DCF analysis uses the forecasted free cash flows of a company and discount them back so as to arrive at the present value estimate, which forms the basis for the potential investment now.
Discounted Cash Flow (DCF) Valuation Analogy
Let us take a simple, discounted cash flow example. If you have an option between receiving $100 today and obtaining $100 in a year’s time. Which one will you take?
Here the chances are more than you will consider taking the money now because you can invest that $100 today and earn more than $100 in the next twelve months’ time. Obviously, you considered the money today because the money available today is worth more than the money in the future due to its potential earning capacity (time value of money concept)
Now, apply the same calculation for all the cash you expect a company to be producing in the future and discount it to arrive at the net present value, and you can have a good understanding of the company’s value.
- The thumb rule states that if the value reached through discounted cash flow analysis is higher than the current cost of the investment, the opportunity would be attractive.
- Please note that DCF analysis entails you to think through various factors that affect a firm likes of future revenue growth and profit margins, cost of equity and debt, and a discount rate that largely depends on the risk-free rate. All of these factors drive the share value and thus enable the analysts to put a more realistic price tag on the company’s stock.
Step by Step Discounted Cash Flow Analysis
As a professional Investment Banker or an Equity Research AnalystEquity Research AnalystAn equity research analyst is a qualified professional who interprets financial information and trends of an organization or industry to provide recommendations, opinions, reports, and projections on the corporate stocks to facilitate equity trading., you are expected to perform DCF comprehensively. Below is a step by step approach of Discounted Cash Flow Analysis (as done by professionals).
Here are the seven steps to Discounted Cash Flow Analysis –
- #1 – Projections of the Financial Statements
- #2 – Calculating the Free Cash Flow to Firms
- #3 – Calculating the Discount Rate
- #4 – Calculating the Terminal ValueCalculating The Terminal ValueThe terminal value formula helps in estimating the value of a business beyond the explicit forecast period. It includes the value of all cash flows, regardless of duration, and is an important component of the discounted cash flow model (DCF).
- #5 – Present Value Calculations
- #6 – Adjustments
- #7 – Sensitivity Analysis
DCF Step #1 – Projections of the Financial Statements
The first thing that needs your attention while applying discounted cash flow analysis is to determine the forecasting period as firms, unlike human beings, have infinite lives. Therefore, analysts’ have to decide how far they should project their cash flow in the future. Well, the analysts’ forecasting period depends on the stages the company is operating, such as early to business, high growth rate, stable growth rate, and perpetuity growth rate.
IMPORTANT – Do have a look at this step by step guide to Financial Modeling in Excel
The forecasting period plays a critical role because small firms grow faster than the more mature firms and thus carry a higher growth rate. So, the analysts’ do not expect the firms to have infinite lives due to the fact that the small firms are more open to acquisition and bankruptcy than the larger ones. The thumb rule says that DCF analysis is widely used during the estimated excess return period of a firm in the future. In other words, a company that stops covering its costs through investments or fails to generate profits, you need not perform DCF analysis for the next five years or so.
Forecasting is done professionally using Financial Modeling. Here you prepare a three statement model along with all the supporting schedules like the depreciation schedule, working capital schedule, intangibles schedule, shareholder’s equity schedule, other long term items schedule, debt schedule, etc.
Projecting the Income Statement
- Here the analysts have to forecast the sales or revenue growth over the next five years, considering that the company will be producing excess return in the next five years. After that, the analysts calculate after-tax operating profits and, at the same time, estimate the expected CAPEX and an increase in net working capital over the forecasted period.
- Thus, the top-line growth or revenue growth becomes the most important assumption in Discounted Cash Flows that the analysts make about the company’s future cash flows.
- Therefore, forecasting top-line growth, we need to take into consideration a wide variety of aspects like historical revenue growth of the company, growth rate of the industry the company is operating in, and growth of the economy or GDP. Many analysts call it top to bottom growth rate, wherein they first look at the growth of the economy, then the industry, and at last, the company.
- However, there is another approach called the internal growth rate formula that comprises of return on equity and growth in retained earnings. Thus, we will take a combined growth rate, comprising of both the top to bottom growth rate and internal growth rate, so as to forecast future revenue.
Projecting the Balance Sheet
- Forecasting the financial statements is not done in sequence in Discounted Cash Flows. All three statements are interconnected, and you will find that while you forecast from the Income Statement, you may have to move to the Balance Sheet and then to the Cash Flows, etc.
- Below is the snapshot of Alibaba Balance Sheet forecasts
Projecting the Cash Flow Statements
- It is not necessary for you to project each and every item on the Cash Flow Statements. Sometimes it becomes practically impossible to do so due to lack of data.
- Here only the necessary items from the Discounted Cash Flow valuation point of view are forecasted.
DCF Step #2 – Calculating Free Cash Flow to Firm
The second step in Discounted Cash Flow Analysis is to calculate the Free Cash Flow to the Firm.
Before we estimate future free cash flow, we have to first understand what free cash flow is. Free cash flow is the cash, which is left out after the company pays all of the operating expenditure and required capital expenditure. The company uses this free cash flow to enhance its growth, such as developing new `products, establishing new facilities, and paying dividends to its shareholders or initiating share buybacks.
Free cash flow reflects the firm’s ability to generate money out of its business, strengthening the financial flexibility that it can potentially use to pay its outstanding net debt and increase value for shareholders.
Calculate FCFF is as follows –
Free Cash Flow to Firm or FCFF Calculation = EBIT x (1-tax rate) + Non Cash Charges + Changes in Working capital – Capital Expenditure
|EBIT x (1-tax rate)||Flow to total capital, Removes capitalization effects on earnings|
|Add: Non-Cash Charges||Add back all noncash charges like Depreciation, Amortization|
|Add: Changes in working capital||It can be outflow or inflow of cash. Watch for large swings year-to-year in forecasted working capital|
|Less: Capital expenditure||Critical to determining CapEx levels required to support sales and margins in the forecast|
After projecting the financials of Alibaba, you can link the individual items as given below to find the Free Cash Flow Projections of Alibaba
Having estimated the free cash flows for the next five years, we have to figure out the worth of these cash flows in the present time. However, to get to know the present value of these future cash flows, we would require a discount rate that can be used to determine the net present value or NPV of these future cash flows.
DCF Step 3- Calculating the Discount Rate
The third step in the Discounted Cash Flow valuation Analysis is to calculate the Discount Rate.
A number of methods are being used to calculate the discount rate. But, the most appropriate method to determine the discount rate is to apply the concept of the weighted average cost of capital, known as WACC. However, you have to keep in mind that you have taken the right figures of equity and the after-tax cost of debt as the difference of just one or two percentage points in the cost of capital will make a vast difference in the fair value of the company. Now, let us find out how the cost of equity and debt are determined.
Cost of Equity
Unlike the debt portion that pays a set rate of interest, Equity does not have an actual price that it pays to the investors. However, it doesn’t mean that equity doesn’t bear a cost. We know that the shareholders expect the company to deliver absolute returnsAbsolute ReturnsAbsolute return refers to the percentage of value appreciation or depreciation of an asset or fund over a certain period. Such assets include mutual funds, stocks and fixed deposits. on their investment in the company. Thus, from the firm’s viewpoint, the required rate of return from the investors is the cost of equity because if the company fails to deliver the required rate of return, then the shareholders will sell their positions in the company. This, in turn, will hurt the share price movement in the stock market.
The most common method to calculate the cost of capital is to apply the capital asset pricing modelApply The Capital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market. or (CAPM). As per this method, the cost of equity would be (Re)= Rf + Beta (Rm-Rf).
- Re= Cost of equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.
- RF= Risk-Free rate
- Β = Beta
- Rm= Market Rate
Cost of Debt
The cost of debt is easy to calculate as compared to the cost of equity. The rate implied to determine the cost of debt is the current market rate that the company pays on its current debt.
For the sake of simplicity in the context of the discussion, I have taken the WACC figures directly as 9%.
IMPORTANT – You can refer to my detailed WACC guide, wherein I have discussed how to calculate this professionally with multiple examples, including that of Starbucks WACC.
DCF Step 4 – Calculating the Terminal Value
The fourth step in Discounted Cash Flow Analysis is to calculate the Terminal Value
We have already calculated the critical components of DCF analysis, except terminal value. Therefore, we will now calculate the terminal value, followed by the calculation of the discounted cash flow analysis. There are several ways to calculate the terminal value of cash flows.
However, the most commonly known method is to apply a perpetuity method using the Gordon Growth ModelGordon Growth ModelGordon Growth Model is a Dividend Discount Model variant used for stock price calculation as per the Net Present Value (NPV) of its future dividends. to value the company. The formula to calculate the terminal value for future cash flow is:
Terminal Value = Final year projected cash flow * (1+ Infinite growth rate)/ (Discount rate-Long term cash flow growth rate)
DCF Step 5 – Present Value Calculations
The fifth step in Discounted Cash Flow Analysis is to find the present values of free cash flows to firm and terminal value.
Find the present value of the projected cash flows using NPV formulas and XNPV formulas.
Projected cash flows of the firm are divided into two parts –
- Explicit Period (the period for which FCFF was calculated – till 2022E)
- Period after the explicit period (post 2022E)
Present Value of Explicit Forecast Period (the year 2022)
Calculate the Present Value of the Explicit Cash Flows using WACC derived above
Present Value of Terminal Value (beyond 2022)
DCF Step 6- Adjustments
The sixth step in Discounted Cash Flow Analysis is to make adjustments to your enterprise valuation.
Adjustments to the Discounted Cash Flow valuations are made for all the non-core assets and liabilities that have not been accounted for in the Free Cash Flow Projections. Valuation may be adjusted by adding unusual assets or subtracting liabilities to find the adjusted fair equity value.
Common Discounted Cash Flow Valuation Adjustments Include –
|Items||Adjustments to DCF (Discounted Cash Flows)|
|Net Debt (Total Debt – Cash)||Market Value|
|Underfunded/overfunded pension liabilities||Market Value|
|Environmental Liabilities||Based on company reports|
|Operating Lease Liabilities||Estimated Value|
|Minority Interest||Market Value or Estimated Value|
|Investments||Market Value or Estimated Value|
|Associates||Market Value or Estimated Value|
Adjust your valuation for all assets and liabilities, for example, non-core assets and liabilities, not accounted for in cash flow projections. The enterprise value may need to be adjusted by adding other unusual assets or subtracting liabilities to reflect the company’s fair value. These adjustments include:
DCF Valuation Summary
DCF Step 7 – Sensitivity Analysis
The seventh step in Discounted Cash Flow Analysis is to calculate the perform calculate sensitivity analysis of the output
It is important to test your DCF model with the changes in assumptions. Two of the most important assumptions that have a major impact on valuations are as follows
- Changes in the Infinite Growth Rate
- Changes in Weighted Average Cost of Capital
We can easily do with Sensitivity Analysis in excel using DATA TABLEs
The below chart shows the sensitivity analysis of Alibaba’s DCF Valuation Model.
- We note that the base case valuation of Alibaba is at $78.3 per share.
- When WACC changes from 9% to say 11%, then the DCF valuation decreases to $57.7
- Likewise, if we change the infinite growth rates from 3% to 5%, then the fair DCF valuation becomes $106.5
Now we have come to know that Discounted Cash Flow Analysis helps to calculate the value of the company today based on the future cash flow. It is because the value of the company depends upon the sum of the cash flow that the company produces in the future. However, we have to discount these future cash flows to arrive at the present value of these cash flows.
This article has been a guide to Discounted Cash Flow Valuation analysis. Here we discuss the 7 step approach to build a Discounted Cash Flow model of Alibaba, including projections, FCFF, discount rate, terminal value, present value, adjustments, and sensitivity analysis. You may also have a look at these following articles to learn more about Valuations –