An Introduction to DCF

Introduction:

DCF, or Discounted Cash Flow, analysis is a method of valuing investments using their expected future free cashflows. The model functions on the premise that the value of a business is equal to the present value of all of its estimated future free cashflows (free cashflows can be understood as the cash a company has remaining after spending the money required to keep the company growing at its current rate – i.e., operating profit less capital expenditure). In order to calculate the present value of cashflows, a discount rate is applied (which can be understood as an interest rate representative of the risk of the investment).

Who uses DCF analysis?

DCF analysis is used by a range of finance professionals in industries such as investment banking, asset management and corporate finance. Any cashflow-generating asset can be valued using a DCF. As a general rule, DCFs are seldom used on their own – they are instead triangulated with trading comparables/transaction comparables and precedents to produce a more reliable valuation.

Discount Rate:

To perform DCF analysis we need to calculate the discount rate that will be used to determine the present value of future free cashflows. This can be done in a number of ways, but the most common is using the WACC.

WACC stands for Weighted Average Cost of Capital (essentially, what average interest rate a company must pay to raise capital, weighted for the debt/equity ratio in their capital structure).

To calculate WACC, we need to identify the cost of equity, the post-tax cost of debt, and weight it based on the proportion of each in the company’s capital structure.

The Cost of Equity can be calculated using the CAPM model, essentially applying the following formula:

Where the Risk-Free Rate is the return on a risk-free investment (usually Treasury Bills), Beta is the volatility of the stock’s performance compared to the market (usually the S&P 500), and the Market Risk Premium is the average performance of the market less the Risk Free Rate.

The Cost of Debt can be calculated by looking at the interest rates being paid on previously-incurred debts – essentially by calculating a weighted average of all prior interest rates that the company has borrowed at.

Now we can calculate our WACC with the following formula:

Where:

E is Equity

D is Debt

Re is Cost of Equity

Rd is Cost of Debt

T is Tax Rate

Future Free Cash Flows:

Now that we have our WACC, we can begin to build our DCF.

The first step is to project out future free cash flows. To calculate current free cash flows, we need data – specifically regarding the company’s operating profit and capital expenditure. This can be found using websites such as yahoo finance, or the company’s quarterly reports.

We then project out these cashflows over a period of time (usually over 5 years) by applying a growth rate, based on industry trends, economic data, and the company's competitive advantages (not by merely extrapolating the current rate of growth). This growth rate is an estimation and may vary between each of the five years based on your assumptions.

Once we have these future cashflows modelled out, we can then discount them into present day values using the following formula:

CFn / (1 + R) ^ n

Where:

CFn = Cash Flow in the Last Individual Year Estimated

R = Discount Rate, or Weighted Average Cost of Capital

n = Number of years in the future

However, it is not possible to project out cashflows to year infinity – to this end we calculate an estimate of all future cashflows after the five-year projection (called the Terminal Value) discounted to that fifth year. This can be calculated using the following formula (aka the perpetuity method)

Terminal Value =

(CFn x (1+ g)) / (R – g)

Where:

CFn = Cash Flow in the Last Individual Year Estimated

g = Long-Term Growth Rate

R = Discount Rate, or Weighted Average Cost of Capital

Once we have this, we still need to discount it back to the present day, so we divide the Terminal Value by (1+R) ^ n to get it in terms of today’s money

To calculate our final valuation, we sum all of the present values (from the 5 projected years and the discounted lump sum perpetuity value). To evaluate an investment opportunity, we often take this total present value and subtract the initial cost of the investment. If the number we calculate is positive, then that investment is likely to be worthwhile, if it is negative, then that investment is unlikely to be worthwhile. This can be applied to fair values to pay for a firm in an acquisition, or to the market cap of a firm listed in a stock market.

It is incredibly important to remember that DCFs are often inaccurate due to the number of assumptions that are made in almost every step of the process. You must sense-check your valuations and use comparables and precedents to create more robust valuations where possible.

Here is a simplified example for you to try:

You are offered the opportunity to purchase a company (House Pharma) for £4,000,000,000. The WACC for this company is 16%. The projected Free Cashflows of this company over the next 5 years are:

Y1: £500 million Y2: £550 million Y3: £570 million Y4: £590 million Y5: £600 million

You expect the long-term growth rate of this company to be around 3%

Calculate the total Present Value of the firm and determine whether it is a worthwhile investment.

Example solution:

As the total present value is larger than the cost of the investment, this is likely to be a worthwhile investment.

(NB manual formulae are shown where possible to aid with learning – excel formulae are to be used when calculating these yourself)

Conclusion:

DCFs are an incredibly common valuation technique and it is great to have a strong understanding of the methodology and the ideas that underpin it. With applications in almost every area of finance, it is a great insight into the kind of work that people in the industry do.

Once you have got to grips with the concepts in this article, practice DCFs on some public companies using data from their reports (or sites like yahoo finance) to build on your valuation skills and remember to always sense-check your work!