What Is Discounted Cash Flow Valuation

What is Discounted Cash Flow Valuation?

Discounted Cash Flow Valuation: This approach is also known as the Income approach, where the value is determined by calculating the net present value of the stream of benefits generated by the business or the asset. Thus, the DCF approach equals the enterprise value to all future cash flows discounted to the present using the appropriate cost of capital.

Major aspects of the DCF model are:          

i)               It weights the time value of money explicitly while evaluating the costs and benefits of a project.

ii)             The focus is on relevant cash inflows and outflows during the entire life if the project as against income as computed in the accrual accounting sense.

iii)            Two main variations of DCF are

-        Net present value (NPV) – the net present value of the total of the present value of the cash flows discounted at a given rate.

-        internal rate of return (IRR) – the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project. It is the yield on investment.

Assumptions of DCF model  

i)        The DCF model relies upon cash flow assumptions such as revenue growth rates, operating margins, working capital needs, and new investments in fixed assets for purposes of estimating future cash flows.

ii)      After establishing the current value, the DCF model can be used to measure the value creation impact of various assumption changes, and the sensitivity tested.

Advantages of DCF Valuation:                                                                       

a.     As DCF valuation is based upon an asset’s fundamentals, it should be less exposed to market moods and perceptions.

b.     DCF valuation is the right way to think about what an investor would get when buying an asset.

c.     DCF valuation forces an investor to think about the underlying characteristics of the firm and understand its business.

Decision rules of DCF models are 

a.     If NPV > 0, then accept project

b.     If NPV = 0, then the project may be accepted only when non-financial considerations are strong enough

c.     If NPV < 0, then reject project

Rank the projects according to their NPVs.

Limitations of DCF Valuation:                           

a.     Since DCF valuation is an attempt to estimate intrinsic value, it requires far more inputs and information than other valuation approaches.

b.     The inputs and information are difficult to estimate, and can also be manipulated by a smart analyst to provide the desired conclusion.

c.     It is possible in a DCF valuation model to find every stock in a market to be over-valued.

d.     The DCF valuation has certain limitations when applied to firms in distress; firms in cyclical business; firms with unutilized assets, patents; firms in the process of reorganizing or involved in the acquisition, and private firms.

Types of companies where we may find difficulties in using discounted cash flow Valuation are:

·      Private firm, where the owner is planning to sell the firm. It is difficult to find out the extent of the success of the private firm, due to the owner's special skills and contacts.

·      A biotechnology firm, with no current products or sales, but with several promising product patents in the pipeline. The difficulty may be in estimating near term cash flows.

·      A cyclical firm, during a recession. The subsequent impact could be adverse/ worsening debt/equity ratios and ROI may also be affected which may create problems.

·      A troubled firm, which is in the process of restructuring, where it is selling some of its assets and changing its financial mix. Difficulties are faced in using historical data for earnings growth and cash flows of the firm.

·      A firm that owns a lot of valuable lands that are currently unutilized. Difficulties are that unutilized assets do not produce cash flows.

The steps in valuing a company using DCF are given below:             

1.     Determine the time horizon for specific forecasts: Consider economic and business cycles, positive and negative growth.

2.     Forecast operating cash flows: Determine value drivers, estimate historic, current, and future ratios, decide on cash/investment policy.

3.     Determine residual value: Decide on residual value methodology, estimate growth rate in perpetuity.

4.     Estimate WACC: Estimate the cost of equity and debt, the debt-equity ratio.

5.     Discount cash flows: Determine enterprise value and equity value, conduct sensitivity analysis.

6.     Prepare related financial statements.

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