Discounted Cash Flow Valuation Method – Overview
The discounted cash flow method is an important and commonly applied valuation method under the income approach in business valuation. It is generally used for businesses that are viewed as an ongoing business, with positive cash flows. It is also a popular company valuation method used in startup valuation as well.
By definition, the Discounted Cash Flow Method values a business based on its future expected net cash flows by applying a discount rate to it to derive the present value. The computation of cash flow has two components: first the cash flow during the forecast period and second, the cash flow during the post forecast period normally referred to as the terminal value.
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. 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 such as the enterprise value.
Key Components of a Discounted Cash Flow 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.
Discounted Cash Flow DCF Methodology
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.
Advantages
- 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.
Disadvantages
- 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 terminal value 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 Discounted Cash Flow DCF Analysis to Derive Enterprise and Equity Values
The following bullet points describes the steps involved in a DFC analysis:
- Project unlevered FCFs;
- 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 financial debt from EV to derive Equity Value;
Speak with our experts to perform a Discounted Cash Flow DCF valuation for your business sale.
