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
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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 • -
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
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Understand the business Good understanding of the Company, Segments, Geographies
Growth strategy, future targets
Strategic priorities
Company
Management background, track record Management
Government policies, Regulations, geo-political environment
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Industry
External Environment
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Industry dynamics, demand, supply, Customer preferences etc.
Analyze historical performance Financial performance
Operating performance Examples
Capacity and utilization
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Growth
Order Book
Price/ Margin per unit
Return on Investment
Financial performance
Capital Efficiency
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Margins
Project future cash flows
Cash flow forecast for 3-5 years TOP DOWN APPROACH
BOTTOM UP APPROACH
• High Level Forecasts based on historical performance - Revenue - Margins - Return on Investment - Capex
• Detailed approach • Forecasts based on operating drivers, Like - Price - Volumes - Production Expense - Capacity/utilization
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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.).
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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. - It is quite detailed - Helps do sensitivity analysis - Helps build scenarios (by changing assumptions)
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- DCF Valuation is Complex and time consuming. - Dependent on multiple assumptions (growth, margins, capex etc.) - Terminal value represents large portion of Total business value - Calculating cost of capital may not be straight forward
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