Discounted Cash Flow (DCF) Analysis

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.

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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.

DCF Methodology

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

Advantages   Disadvantages
  • Theoretically, the DCF is arguably the most sound method of valuation.
  • The DCF method is forward-looking and depends more future expectations rather than historical results.
  • The DCF method is more inward-looking, relying on the fundamental expectations of the business or asset, and is influenced to a lesser extent by volatile external factors.
  • The DCF analysis is focused on cash flow generation and is less affected by accounting practices and assumptions.
  • The DCF method allows expected (and different) operating strategies to be factored into the valuation.
  • The DCF analysis also allows different components of a business or synergies to be valued separately.
  • The accuracy of the valuation determined using the DCF method is highly dependent on the quality of the assumptions regarding FCF, TV, and discount rate. As a result, DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs. It is also common to run the DCF analysis for different scenarios, such as a base case, an optimistic case, and a pessimistic case to gauge the sensitivity of the valuation to various operating assumptions. While the inputs come from a variety of sources, they must be viewed objectively in the aggregate before finalizing the DCF valuation.
  • The TV often represents a large percentage of the total DCF valuation. Valuation, in such cases, is largely dependent on TV assumptions rather than operating assumptions for the business or the asset.

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 spreadsheetdownload 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.