The DCF method
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The whole purpose of performing fundamental analysis and understanding the performance of a company is only a sort of a preamble to valuation, as we saw in the earlier chapters. But the real question is – how do you go about valuing a company’s stock? Is there any specific method to do that?
Well, actually, there are several methods to value a business. We’ll cover them in the coming chapters. And while we’re at it, we’ll begin with the Discounted Cash Flow (DCF) method. The DCF model has many layers, but it’s one of the most absolute ways to value a business. Absolute? What does that mean? If that’s what you’re wondering, we’ll explain.
You see, some valuation methods take into account many external, relative factors like the value of a similar company to arrive at how much a specific company is worth. But the DCF method isn’t like that. It makes use of the company’s own data points to figure out its worth, making it absolute and relevant to the company being valued.
What is the Discounted Cash Flow method all about?
Basically, this method aims to project the future free cash flows that a business is likely to enjoy. The terminal value is also projected. Thereafter, these future free cash flows and the terminal value are all discounted to arrive at their current or present value. The sum of the discounted present values of all future cash flows and the discounted terminal value is determined as the value or the worth of a company. We’ll take a look at the step-by-step guide in a bit to understand the nuances of this method.
But first, let’s quickly revisit and address three important questions.
- What are free cash flows?
- What is the terminal value of a business?
- And why are future cash flows discounted?
What are free cash flows?
Free cash flow is a term that refers to the cash that remains after the company pays all of its capital expenses and operating expenses. The company can then use this cash to grow its business, to develop new products and services or to pay dividends to its shareholders.
To calculate the free cash flows, you can use this formula.
Start with: |
EBIT x (1 – tax rate) |
Add: |
Non-cash charges like depreciation and amortisation |
Add/subtract: |
Changes in working capital |
Subtract: |
Capital expenditure |
Result: |
Free cash flow for that period |
What is the terminal value of a business?
The terminal value is basically the value of the company for the period that comes after the years for which you’re forecasting the future free cash flows. It operates under the assumption that a company will continue to grow at a particular rate for the foreseeable future, beyond the forecasted period. We call this the terminal growth rate or the infinite growth rate.
To calculate the terminal value, you can use this formula.
Terminal value = [The projected free cash flow in the final year of the forecast period x (1 + terminal growth rate)] ÷ [discount rate – terminal growth rate] |
Why are future cash flows discounted?
Say a company’s free cash flows grows at 6%. And this year, the cash flows amount to Rs. 50,000. Using the DCF model, you forecast that the free cash flows next year will amount to Rs. 53,000. And in the next year, say it will amount to Rs. 56,180. This method requires you to discount all the future cash flows (here, Rs. 53,000 and Rs. 56,180) using a discount rate. Why is that?
As we saw in the previous chapter, it’s because the value of money fluctuates across time. In other words, the value of money receivable in the future is worth less today. That’s why the DCF method requires you to discount the future cash flows and terminal value.
Defining the DCF method
In finance, the Discounted Cash Flow technique is a method of valuing a company using the concept of time value of money. All the future free cash flows are estimated and discounted to give their present values (PVs). Thereafter, the sum of all the future cash flows is the net present value (NPV). This is considered to be the value of the company.
The steps involved in the DCF model
Irrespective of the company you’re evaluating, the DCF method has a set of finite steps that can be applied across companies, no matter what industry they belong to. Let’s see how this works.
- Determine the forecasting period.
- Calculate the free cash flows to the company over the course of the forecasting period.
- Calculate the rate at which you’ll discount the future cash flows.
- Determine the terminal value of the business.
- Discount the future cash flows and the terminal value to arrive at the present value of the company.
In some cases, after arriving at the company value or the enterprise value, adjustments are made to calculate the net present value of equity. What are these adjustments, exactly? Well, that’s simple. Basically, the value of debt is subtracted from the value of the company to arrive at the value of equity.
Here’s the formula.
Value of equity = Value of the company – Value of debt |
The value of debt is basically the sum of all the borrowings in the company’s name as on the date of valuation. When you subtract the value of this debt from the company’s value, you get the actual value of the equity. This is what you will get to enjoy if you invest in the company’s equity.
What are the pros and cons of the DCF model?
Like all valuation methods, the Discounted Cash Flow method has its strengths and weaknesses. Let’s look at some of these.
The pros of the DCF valuation method
- Firstly, the DCF model is an intricate and detailed method that considers all the quantitative metrics about a company.
- The DCF method also allows you to factor in the expectations from the company’s future business.
- It helps determine the intrinsic value of a company, so you can easily determine whether the shares of the company are overvalued or undervalued.
The cons of the DCF valuation method
- On the downside, the Discounted Cash Flow method requires you to make several assumptions. The probability of the real metrics being close to these assumptions could be quite low.
- The DCF method can also appear to be too complex for some investors.
Wrapping up
This is the basic structure of the DCF method. In later chapters, we’ll get into the details of how you build your DCF valuation model. But before we get to that point, we’ll need to look at other methods of valuing a company. Beyond the DCF method, there are many other techniques that help you assess the value of a business - both subjectively and absolutely. Head to the next chapter to learn more.
A quick recap
- The DCF method makes use of the company’s own data points to figure out its worth, making it absolute and relevant to the company being valued.
- This method aims to project the future free cash flows that a business is likely to enjoy. The terminal value is also projected.
- Thereafter, these future free cash flows and the terminal value are all discounted to arrive at their current or present value.
- The sum of the discounted present values of all future cash flows and the discounted terminal value is determined as the value or the worth of a company.
- Free cash flow refers to the cash that remains after the company pays all of its capital expenses and operating expenses.
- The terminal value is the value of the company for the period that comes after the years for which you’re forecasting the future free cash flows.
- In some cases, after arriving at the company value or the enterprise value, adjustments are made to calculate the net present value of equity.
- The value of debt is subtracted from the value of the company to arrive at the value of equity.