Discounted Cash Flow Valuation: What, How, and Methodology in 4 Easy Steps
Updated: Oct 14, 2022
The discounted cash flow (DCF) method is the most widely used valuation technique in the world of start-ups. It is based on the concept that the value of a company is equal to the present value of all future cash flows.
The Discounted Cash Flow (DCF) valuation model was invented by Dr. John Burr Williams in the 1930s. Williams was a professor of accounting at Harvard University, and his book "The Theory of Investment Value" had a huge impact on how stocks were valued at the time.
The model is simple: you take the present value of your company's expected future cash flows and add them up. For this to be a valid method, you need to estimate future revenues and expenses accurately. Sometimes this can be tricky because so much depends on how well you execute or if a competitor beats you to market with a similar product or service.
The DCF formula assumes that value is generated from a business's future cash flow and discounted back to the present day using a discount rate determined by a company’s risk characteristics and growth potential to measure a business’s intrinsic value. The goal of discounted cash flow valuation is to determine what the business would be worth in the immediate future if it shut down or was sold.
Table of Contents
Why Understanding DCF is so Important?
DCF is an almost universally used model because projects with high expected returns have a large cash generation capability, which generally results in these projects only being funded if they have acceptable risks or high hurdle rates. Measures like internal rate of return (IRR), net present value (NPV), and modified internal rate of return (MIRR) are all derived from DCF.
DCF can be used for valuing any business with predictable cash flows, including private companies and public businesses. It's also useful for valuing a single asset like real estate or bonds.
Discounted Cash Flow Valuation is also the most common form of valuation used by investment banks when they are valuing companies for mergers and acquisitions or when they are doing initial public offerings (IPOs). This is because it considers many factors that other methods don’t take into consideration, such as taxes, capital expenditures, depreciation, and more.
What is Free Cash Flow?
Free cash flow is the money that a company generates after paying all its expenses, debts, and taxes. It can be used to pay dividends to shareholders, buy back stock or pay off debt. In other words, it's the cash left over after all the expenses are paid.
FCF is an important metric that investors use to determine whether a company can pay its debts and investments while still making a profit.
FCF is so important because it's a measure of profitability and earning power. The higher a company's FCF, the more likely it is that you'll receive your expected return on investment if you buy its stock.
Net Income + Depreciation (Non-cash expenses) - Capital Expenditures – Increase in Working Capital - Taxes Paid = Free Cash Flow
Operating Cash Flow minus Capital Expenditure- This reflects the amount of cash generated by a company's core business activities, such as sales and delivery of goods or services. Capital Expenditure refers to the amount spent on buying new equipment or buildings that are needed for day-to-day operations. These investments usually don't generate any revenue until they're paid off or sold later (if at all).
For example, if you invest $100 in a company and they pay you back $125 in interest payments every year, your total cash flow will be $125. On the other hand, if you invest $100 in a company and they pay you back $80 in interest payments every year and spend $20 on new equipment, your free cash flow will be only $60 because you received only $80 from them in interest payments but spent $20 on equipment.
What is Discount Rate?
The discount rate is used in discounted cash flow valuation to determine what a future dollar is worth today. The discount rate signifies how much investors require to invest in an investment project today, knowing that they will receive their money back in the future.
The discount rate is the return that an investor would expect from investing in the company. It is also called the required rate of return or cost of equity.
The Discount Rate for Startups – Startups lack track records, so how do you determine an appropriate discount rate for your startup? If you're just starting, there's no way to know how much potential your company has. Therefore, it's reasonable to assume that your company has no value since it hasn't been profitable yet. However, once you've been operating for several years and have begun turning profits, there are better ways to determine what discount rate is appropriate for your business.
The discount rate could be determined based on the interest rate on government bonds in your country (or currency). For example, if U.S. Treasuries are trading at 2%, you could use that as your discount rate. This would mean that $1 received 1 year from now would be worth $0.98 today (1/ (1+2%) - 1).
What is the Terminal Value?
Terminal value is the value of a company's assets after all future cash flows have been discounted. The terminal value is an estimate of the ultimate worth of a business based on its projected financial performance after it has reached the end of its growth phase. In other words, it is the expected value of all future cash flows after the growth phase ends (which is usually when the business matures).
Terminal values are typically calculated using a perpetuity growth model. The perpetuity growth model assumes that there will be no growth of income beyond a certain point in time.
For example, if you have an investment that pays $100 per year forever, then your terminal value would be $100 per year forever (assuming no additional investments). This means that there is no discounting of future cash flows beyond this point in time.
How to do Discounted Cash Flow Valuation?
The discounted cash flow valuation model can be complex, but it is one of the most important valuation models for shareholders as it looks at future cash flows generated by a company to estimate its value.
1. The first step in calculating DCF value is to estimate future free cash flows (FCFs) for each year in the projection period.
2. Then, you should discount these future FCFs back to present value using an appropriate discount rate (discounted rate).
To calculate the discounted rate, we need some information about your business – namely growth rates and the riskiness or uncertainty of those growth rates.
3. Growth rates are usually estimated using the past performance of your company or industry or by using forecasts provided by analysts or other sources like government agencies.
4. Lastly, we add back the 'Terminal Value' in Year ‘n’ to arrive at a total business valuation for the company.
Example With Calculation
Let's say you're trying to value a company that makes smart contact lenses that measure blood sugar levels in diabetics and send this data to their smartphones. The company has raised $10 million in funding from VCs and angels, which valued it at $50 million pre-money (meaning before accounting for dilution). You think it will grow sales by 50 percent per year and increase its user base by 10 percent per quarter for the next five years, after which it will plateau at 25 million users per quarter. After discounting these future cash flows back to today's dollars using a 7 percent discount rate, you come up with a present value of $85 million (1/1/ (1+0.07)-1).
Advantages of DCF Valuation
Discounted cash flow models are used in equity research, debt analysis, and investment banking.
The discounted cash flow model can be used to calculate the intrinsic value of stocks, bonds, or other financial instruments.
It's flexible — You can adjust your assumptions about growth rates, risk, and cost of capital to get different outcomes for your valuation.
It's simple — The calculations involved in DCF are relatively straightforward compared with other methods such as multiples analysis or precedent transactions analysis. All you need is financial data from the company being valued and an estimate for future cash flows.
It provides a comparable valuation metric for assets and businesses of different sizes and types. This is because it treats all assets as generating cash flows that are discounted at the same rate regardless of their size or industry.
It accounts for risk.
Can be used to determine whether an investment is undervalued or overvalued relative to its competitors.
Ability to analyze how changes in key assumptions (growth rates, margins) will impact valuation conclusions.
Provides investors with insight into how much money a company can be expected to generate in the future.
Disadvantages of DCF Valuation
It requires more information than other methods such as comparable company analyses or precedent transactions, which can make it difficult to apply consistently across different companies with different financial situations; for example, some companies may have higher growth rates than others or use different capital structures (debt vs. equity).
Discounted cash flow valuations require some degree of forecasting into the future, which may not always be accurate.
It's difficult to calculate the value of stocks because they don't pay dividends regularly only once per year or even less frequently than that.
There are many factors involved in estimating a stock's value using discounted cash flow valuation, including interest rates, growth rates, and payout ratios (how much money is reinvested back into operations). These factors can vary widely between industries and companies and therefore may not always be as accurate as investors would like them.
It requires historical data for comparable companies which may not be available for start-ups, and it doesn't provide an exit multiple.
It’s not easy to forecast revenues and expenses over time.
Cash flow forecasts are subject to error as well as changes in market conditions.
The present value of all future cash flows must be calculated for each year — even if no cash will be generated until a later year — which can lead to inaccuracies if any assumptions are incorrect.
The discounted cash flow valuation method of stock valuation adjusts the present value of all future expected cash flows to reflect the riskiness of the investment. This approach is best suited to companies with established histories that can be projected into the future, which then allows for useful estimates for interest rates, growth, and other variables. Though rooted in theory and abstract math, discounted cash flow valuation is used in many practical applications. For example, it is one of several approaches used when a company "goes public" by selling stock to outside investors.
While the DCF method is useful, it must be used with extreme care. Many intangible and non-marketable assets cannot be valued by this approach. Correctly applied, the Discounted Cash Flow Method should be a positive addition to any valuation professional's toolkit.
DCF analysis can be applied to both private companies and public companies.
DCF models are often used as part of an initial public offering (IPO) analysis or for determining whether it's worthwhile for private equity firms to invest in certain deals.
You can read our other blogs here:
5 Benefits of Relative Valuation with Formula and Example
Intrinsic Valuation: What, why, 3 Easy Methods, and Formula