The DCF analysis describes the net present value (NPV) of cash flows projected to be available to all capital providers, including the cash needed to be invested for generating projected business growth. The concept of DCF valuation is based on the fact that the value of a firm or asset is based on its ability to generate cash flows for the capital providers. With this in mind, this analysis relies more on the fundamental expectations of the business than anything else and is more theoretical than practical. A DCF analysis gives the overall value of a business (i.e. the EV)
Key Components of a DCF
- Free cash flow (FCF): cash generated by both tangible and intangible business assets available for distribution to all capital providers. This type of cash flow is often referred to as unlevered free cash flow as it encompasses cash flow available to all providers of capital and is not affected by the capital structure of the business.
- Terminal value (TV): the 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 valuation involves estimating FCF over its projection period, working out the value at the end of that period and discounting the estimated FCFs and terminal value using the discount rate. This will ensure that you arrive at the NPV of the total expected cash flow(s) of whatever you are measuring.
- The DCF is considered to be one of the more sound methods of valuation.
- The DCF method depends more on future expectations than previous results and relies on the expectations implicit in a given business or asset. It is less influenced by external factors.
- The DCF analysis focuses on generating cash flow and is less affected by accounting practices and assumptions.
- The DCF method allows a variety of 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 DCF valuation depends highly on the quality of the assumptions fed into the equation (i.e. FCF, TV and discount rate). Because of these reasons, DCF valuations are usually expressed as a range rather than a single discrete value. It is possible to run multiple analyses for different scenarios to gauge the sensitivity of the DCF valuation under various operating assumptions. This method would allow the user to see the effects of, for example, a pessimistic valuation. It is important to note that, as inputs into the equation come from a variety of sources, they must be viewed objectively in the aggregate report before the final DCF valuation is made.
- The TV often plays a big part in the total DCF valuation. Valuation, in such cases, is largely dependent on TV assumptions rather than any operating assumptions.
Steps in the DCF Analysis
The following bullet points describes the steps involved in a DFC analysis:
- Project unlevered FCFs (UFCFs);
- Choose a discount rate;
- Calculate the TV;
- Calculate the EV (discount the projected UFCFs and TV to net present value);
- Calculate the equity value by subtracting net debt from EV;
- Review and finalise the results.
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