Discounted Cash Flow (DCF)

What is Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) valuation model determines the company’s present value by adjusting future cash flows to the time value of money. This DCF analysis assesses the present fair value of assets or projects/companies by addressing factors like inflation, risk, cost of capital, analyzing the company’s future performance.

In other words, DCF valuation model 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

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Source: Discounted Cash Flow (DCF) (wallstreetmojo.com)

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 conceptTime Value Of Money ConceptThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more)

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.

Assuming that you understood this simple DCF stock example, we will now move the practical Discounted Cash Flow Example of Alibaba IPOAlibaba IPOAlibaba is the most profitable Chinese e-commerce company and its IPO is a big deal due to its size. With its huge size and network, Alibaba IPO may look at international expansion beyond China and may lead to price wars and intensive competition in the US.read more.

7 Step of Discounted Cash Flow Valuation Model

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.read more, you are expected to perform DCF comprehensively. Below is a step by step approach of Discounted Cash Flow Analysis (as done by professionals).

Seven Steps to DCF

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Source: Discounted Cash Flow (DCF) (wallstreetmojo.com)

Here are the seven steps to Discounted Cash Flow (DCF) Analysis –

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.

Step 1 - DCF

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 ModelingFinancial ModelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more. Here you prepare a three statement model along with all the supporting schedules like the depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more schedule, working capital schedule, intangibles schedule, shareholder’s equity EquityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more schedule, other long term items schedule, debt schedule, etc.

Projecting the Income Statement

Alibaba DCF Step 1

Projecting the Balance Sheet

Alibaba DCF Step 1 - balance sheet

Projecting the Cash Flow Statements

Alibaba DCF Step 1 - Cash Flows

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.

Step 2 - DCF

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 buybacksShare BuybacksShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more.

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 FCFFCalculate FCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.read more 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

FormulaComments
EBIT x (1-tax rate)Flow to total capital, Removes capitalization effects on earnings
Add: Non-Cash Charges Add back all noncash chargesNoncash ChargesNon-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation.read more like Depreciation, Amortization
Add: Changes in working capitalIt can be outflow or inflow of cash. Watch for large swings year-to-year in forecasted working capital
Less: Capital expenditureCritical 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

Discounted Cash Flow Step 2 - FCFF

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 NPVNet Present Value Or NPVNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more of these future cash flows.

Step 3- Calculating the Discount Rate

The third step in the Discounted Cash Flow valuation Analysis is to calculate the Discount Rate.

Step 3 - DCF

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 debtAfter-tax Cost Of DebtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more 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.read more 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.read more or (CAPM). As per this method, the cost of equity would be (Re)= Rf + Beta (Rm-Rf).

Where;

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%.Discounted Cash Flow Step 3 - WACC

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.

Step 4 – Calculating the Terminal Value

The fourth step in Discounted Cash Flow Analysis is to calculate the Terminal Value

Step 4 - DCF

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. read more 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)

Discounted Cash Flow Step 4 - Terminal Value 1

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.

Step 5 - DCF

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)
Discounted Cash Flow Step 5

Present Value of Explicit Forecast Period (the year 2022)

Calculate the Present Value of the Explicit Cash Flows using WACC derived above

Discounted Cash Flow Step 5 - present value

Present Value of Terminal Value (beyond 2022)

Discounted Cash Flow Step 5 - present value of terminal value

Step 6- Adjustments

The sixth step in Discounted Cash Flow Analysis is to make adjustments to your enterprise valuation.

Step 6 - DCF

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 valueEquity ValueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.read more.

Common Discounted Cash Flow Valuation Adjustments Include –

ItemsAdjustments to DCF (Discounted Cash Flows)
Net DebtNet DebtDebt minus cash and cash equivalents equals net debt, which is the amount of debt a company has in comparison to its liquid assets. It is a metric that is used to evaluate a firm's financial liquidity and aids in determining if the company can meet its obligations by comparing liquid assets to total debt.read more (Total Debt – Cash)Market Value
Underfunded/overfunded pension liabilitiesMarket Value
Environmental LiabilitiesBased on company reports
Operating LeaseOperating LeaseAn operating lease is a type of lease that allows one party (the lessee), to use an asset held by another party (the lessor) in exchange for rental payments that are less than the asset's economic rights for a particular period and without transferring any ownership rights at the end of the lease term.read more LiabilitiesEstimated Value
Minority InterestMinority InterestMinority interest is the investors' stakeholding that is less than 50% of the existing shares or the voting rights in the company. The minority shareholders do not have control over the company through their voting rights, thereby having a meagre role in the corporate decision-making.read moreMarket Value or Estimated Value
InvestmentsMarket Value or Estimated Value
AssociatesMarket 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

Discounted Cash Flow Step 6 - Adjustments1

Step 7 – Sensitivity Analysis

The seventh step in Discounted Cash Flow Analysis is to calculate the perform calculate sensitivity analysisCalculate Sensitivity AnalysisSensitivity analysis is a type of analysis that is based on what-if analysis, which examines how independent factors influence the dependent aspect and predicts the outcome when an analysis is performed under certain conditions.read more of the output

Step 7 - DCF

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 excelSensitivity Analysis In ExcelSensitivity analysis in excel helps us study the uncertainty in the output of the model with the changes in the input variables. It primarily does stress testing of our modeled assumptions and leads to value-added insights. In the context of DCF valuation, Sensitivity Analysis in excel is especially useful in finance for modeling share price or valuation sensitivity to assumptions like growth rates or cost of capital.read more using DATA TABLEs

The below chart shows the sensitivity analysis of Alibaba’s DCF Valuation Model.

Discounted Cash Flow Step 7 - Sensitivity analysis
  • 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

Conclusion

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.

Recommended Articles

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 –

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