How Discounted Cash Flow (DCF) Modeling Works?
A Discounted Cash Flow (DCF) valuation model is one of the financial planning tools used for investment or business valuation. In contrast with Comparative Analysis, the DCF Model focuses on the business’s intrinsic value and not on the value commanded by market investors and speculators. Also, the DCF model uses cash flows, reflecting the actual business performance instead of accounting profits. However, it is a complicated model that requires deep financial know-how and the ability to provide reliable assumptions.
The DCF model can be utilized for different purposes. The most common reasons are:
1. Entire Business Valuation
2. Business Component Valuation
3. Stocks or Bonds Valuation
4. Income-generating Property Valuation
The Four Major Components of a DCF Model
There are four factors to consider in computing the DCF model:
1. Free Cash Flows
2. Discount Rate
3. Projected Time
4. Terminal Value
1. Free Cash Flows
There are two cash flows used for business valuation, the levered and unlevered cash flows. Levered cash flow is the cash flow after deducting the financial obligations (loan repayments, interest), while unlevered cash flow is before deducting the financial obligations.
The DCF model primarily used the unlevered free cash flow since this is the cash flow available to equity and debt holders. On the other hand, levered cash flow is beneficial to investors, showing the cash available for expansion.
2. Discount Rate
The discount rate is the expected rate of return of similar-risk investments. The most used discount rate is the Weighted Average Cost of Capital (WACC), representing equity and debt capital.
3. Projected Time
The period will depend on the frequency of projections — it can be monthly, quarterly, or annually. Cash flows are then discounted back based on the frequency of projections.
4. Terminal Value
For business valuation, it typically forecasts 5–10 years of free cash flows. Terminal Value represents future cash flows at the end of the projected years since it is difficult to provide reliable estimates that are far into the future.
The widely used method to compute for Terminal Value is the Exit Multiple, where the business is assumed to be sold in the future. The other method is Perpetual Growth, which is mainly utilized by academics. Perpetual Growth assumes that the business will grow at a reasonable fixed growth forever. For this article, we will use the Exit Multiple Approach.
Discounted Cash Flow Illustration in Excel
Discounted cash flow, also known as Net Present Value, is the sum of the free cash flows divided by one plus the discount rate raised to the power of time.
Formula: CF/(1+r)1 + CF/(1+r)2 + CF/(1+r)3 + … + CF/(1+r)n
To illustrate how to compute DCF in Excel, let’s take the example below. Unlevered free cash flows for five years are $150, $200, $225, $275, and $300, respectively. Terminal value is projected at $700. Discounted factor decreases as computed farther from the present. Considering the free cash flows, terminal value, and discount rate, computed DCF is $1,224.
To compute the Equity Value, we add the cash then deduct the financial debt, resulting in $1,474, as shown in the table below.
After understanding how the discounted counted cash flow is computed, you can now better grasp how it works in an actual business, as shown in the sample DCF model below.
Free cash flows to firm (FCFF) or the unlevered free cash flows are computed by utilizing the accounts below:
● Earnings before Interest and Taxes (EBIT)
● Adjusted Taxes which is the applicable income tax rate applied to EBIT
● Adding back Depreciation and Amortization
● Adjustment for changes in Net Working Capital
● Deduction of CAPEX
Terminal Value can also be computed using an EV/EBITDA multiple. The EV/EBITDA or Enterprise Value over EBITDA multiple differ across industries. Financial analysts widely use it since the EV/ EBITDA multiple provides a normalized ratio for the difference in capital structure, capital expenditure, taxes, and operations of various companies.
Financial analysts and business decision-makers utilize the DCF model for their project or business valuation to assess the viability of a prospect investment or when planning to sell a company. DCF model shows the intrinsic business valuation — a more realistic approach.
There are widely available financial model templates available online. These templates incorporate the DCF model as one of the financial metrics in assessing a project’s viability.
