The discounted cash flow (DCF) analysis represents the net present value (NPV) of projected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth. The concept of DCF valuation is based on the principle that the value of a business or asset is inherently based on its ability to generate cash flows for the providers of capital. To that extent, the DCF relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach relying on numerous assumptions. A DCF analysis yields the overall value of a business (i.e. enterprise value), including both debt and equity.
Key Components of a DCF
- Free cash flow (FCF) – Cash generated by the assets of the business (tangible and intangible) available for distribution to all providers of capital. FCF is often referred to as unlevered free cash flow, as it represents cash flow available to all providers of capital and is not affected by the capital structure of the business.
- Terminal value (TV) – Value at the end of the FCF projection period (horizon period).
- Discount rate – The rate used to discount projected FCFs and terminal value to their present values.
The DCF method of valuation involves projecting FCF over the horizon period, calculating the terminal value at the end of that period, and discounting the projected FCFs and terminal value using the discount rate to arrive at the NPV of the total expected cash flows of the business or asset.
Exhibit A – Advantages and Disadvantages
Steps in the DCF Analysis
The following steps are required to arrive at a DCF valuation:
- Project unlevered FCFs (UFCFs)
- Choose a discount rate
- Calculate the TV
- Calculate the enterprise value (EV) by discounting the projected UFCFs and TV to net present value
- Calculate the equity value by subtracting net debt from EV
- Review the results
Exhibit B – DCF Template
The following spreadsheet shows a concise way to build a "best-practices" DCF model. Calculation of unlevered cash flow may be modified as warranted by your specific situation. Each of the steps required to conduct a DCF analysis are described in more detail in following sections. You can download this DCF template.
Note that while unlevered free cash flow inputs are hard-coded in blue here, they would normally be linked to income and cash flow statement items in practice.