What is Discounted Cash Flow (DCF) Valuation
What is Discounted cash flow valuation? • DCF valuation includes estimation of cash flow generated by a business over long term and then discount the cash flows to present time. •
Present value of cash flows till perpetuity (over long term) is the intrinsic value of the Company.
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This method is also known as intrinsic value method
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Estimating future cash flows requires a good understanding of the industry, business and economy.
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Where can Discounted cash flow method be used Evaluation of a project or investment
Valuation of bonds
Valuation of a business
Valuation of shares of a Company Email: Support@skillfinlearning.com
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How to discount future cash flows? • DCF method involves forecasting the future cash flows from a business and then discounting those cash flows to the present period. • DCF Value = Present value of cash flows at end of period 1+Present value of cash flows at end of period 2+ Present value of cash flows at end of period 3+⋯+Present value of cash flows at end of period n
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Present value of cash flows = CF / (1+r)^t Where, CF = Net Cash Flow at the end of year t t = Time period (year) r = discount rate or the cost of capital
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Steps to build a DCF model 1
Understand the business Analyze historical performance
2 3
4 5
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Project Future cash flows Calculate Terminal Value
Discount the Cash Flows using WACC Mobile: 9650010925
Understand the business Good understanding of the Company, Segments, Geographies
Growth strategy, future targets
Strategic priorities
Company
Management background, track record Management
Industry
External Environment Government policies, Regulations, geo-political environment Email: Support@skillfinlearning.com
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Industry dynamics, demand, supply, Customer preferences etc.
Analyze historical performance Financial performance
Operating performance Examples
Growth
Price/
Order Book
Return on Investment
Margin per unit
Capacity and utilization
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Financial performance
Capital Efficiency
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Margins
Project future cash flows
Cash flow forecast for 3-5 years TOP DOWN APPROACH • High Level Forecasts based on historical performance - Revenue - Margins - Return on Investment - Capex
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BOTTOM UP APPROACH • Detailed approach • Forecasts based on operating drivers, Like - Price - Volumes - Production Expense - Capacity/utilization Mobile: 9650010925
Calculate terminal value Terminal value is calculated after the forecast period (3-5 years)
Perpetual growth method •
Exit multiple method •
Assumes cash flows to grow at a stable rate till perpetuity.
g = Growth rate till perpetuity WACC = Weighted average cost of capital or Discount rate
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Terminal value calculated based on average historical multiples (EV/EBIT, EV/NOPAT etc.) or transaction multiples for deals in the same industry (Transaction value/ EBITDA etc.).
Discount the cash flows using Weighted average Cost of capital •
DCF method involves forecasting the future cash flows from a business and then discounting those cash flows to the present period.
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Discounted cash flow method – Advantages and Limitations
- DCF method calculates the intrinsic value of the business based on future cash flows.
- DCF Valuation is Complex and time consuming.
- Helps do sensitivity analysis
- Dependent on multiple assumptions (growth, margins, capex etc.)
- Helps build scenarios (by changing assumptions)
- Terminal value represents large portion of Total business value
- It is quite detailed
- Calculating cost of capital may not be straight forward
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