DCF MODEL

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What is a Discounted Cash Flow Model?

The discounted cash flow (DCF) model is a type of financial model

that values an investment by forecasting its cash flows into the
future and calculating the present value of those cash flows by
discounting them. Cash flows are discounted using the rate of return
determined by the modeler.

The DCF model estimates a company’s intrinsic value (value based

on a company’s ability to generate cash flows) and is often
compared to the company’s market value.

If a company’s intrinsic value is greater than the market value of the

company, the stock is said to be undervalued. The converse is that a
company valued at less than its market value is unlikely to be a good
investment.

Discounted Cash Flow Formula:

The theoretical value of a stock is equal to the present value of the

cash return you could earn by holding the stock (income method)

CFi: the cash flow for the given year

r: the discount rate

t: time period

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Free Cash Flow Explained

The only criterion that an investor should consider in decision-

making is not whether a company has a competitive advantage, but
whether this competitive advantage can bring more cash to
investors in the future.

A DCF model can be based on the free cash flow to the firm (FCFF)
or the free cash flow equity (FCFE).

Free cash flow is the amount of cash a company generates (net of

tax) after accounting for non-cash expenses, CAPEX, and any
change in operating assets and liabilities.

Analysts use free cash flow rather than EBITDA or Net Income
because those metrics omit capital expenditures and changes in
cash from changes in operating assets and liabilities.

Net income is calculated based on non-cash expenses as well and

does not accurately reflect the cash flow to the company.

Free cash flow can also be referred to as unlevered free cash

flow since it doesn’t take into account interest expense or net debt
issuance (repayment).

Free cash flow to equity is also known as levered free cash flow
because it takes interest expense and net debt issuance
(repayment) into account.

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Why Is the Cash Flow Discounted?

In a valuation based on discounted cash flow, the present value is

usually calculated as of the current date.

This model is based on the time value of money, which states that a
dollar today is worth more than a dollar in the future.

Money today can be invested to generate a return, which is what

makes today’s dollar more valuable.

Cost of Capital

Analysts often use the Weighted Average Cost of Capital (WACC),

which represents a company’s average cost of capital including
both equity and debt, in DCF models.

WACC can be considered the rate of return that stockholders and

bondholders require to provide capital.

It can also be thought of as a firm’s opportunity cost; if a company

can’t find a higher rate of return elsewhere, they should buy back
their own shares.

The riskier a company, the higher its WACC.

To the extent a company achieves rates of return above their cost of

capital (their hurdle rate), they are creating value.

If they are earning a rate of return below their cost of capital, then
they are destroying value.

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Discounted Cash Flow Usage

The DCF model is used widely in practice as well as in academia.

A company valuation is a basis for investment and transaction

pricing, and investors ultimately make investment recommendations
and decisions based on the valuation.

This applies to an investor acquiring a company or buying stock.

Business owners and managers can make capital budgeting or
operating expenditure decisions based on DCF modeling.

The DCF valuation method is the most rigorous method for valuing
companies and stocks, and in principle is applicable to any type of
company. However, it is usually more suitable for companies with
more predictable cash flows.

In contrast with a market-based valuation like a comparable

company analysis, the idea underlying the DCF model is that the
value of a company is not a function of arbitrary supply and demand
for that company’s stock.

Instead, the value of a company is a function of a company’s ability

to generate cash flow in the future for its shareholders.

Absolute vs Relative Valuation

Company value can be estimated by the absolute valuation method

and the relative valuation method. In theory, the enterprise value or
equity value estimated by various methods should be consistent.

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Limitations of a DCF

The DCF model’s main limitation is that it requires many assumptions

and is only as good as those assumptions.

For example, an investor needs to accurately estimate future cash

flows.

These future cash flows rely on a multiplicity of factors, everything

from market demand and competitive advantage to economic
conditions, technology, and potentially, geopolitical considerations.

Unforeseen threats and opportunities can both have significant

impact on projections.

A cash flow estimate that’s too high can lead to making a bad
investment, while an estimate that’s too low can make a company
look expensive and cost the investor an attractive opportunity.

It’s also vital to choose an appropriate discount rate, which

represents the required rate of return on the investment.

Future cash flows are reduced by the discount rate, so the higher the
rate the lower the present value will be.

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Basic DCF calculation

A project has the following cash flows: T0 Outflow $110,000, T1-4 Inflow
$40,000. At the company’s cost of capital of 10%, the NPV of the
project is $16,800.

Considering inflation and taxation, the NPV

presentation is structured as follows:

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Conclusion

DCF valuations depend on factors including cash flow and discount

rate while comparative valuations look at comparable companies. In
practice, valuation is affected by a multitude of factors, both external
and internal.

Therefore, analysts typically use multiple relative valuation methods

and at least one absolute valuation method, mainly DCF. They also
use sensitivity analysis to give a reasonable valuation range and
constantly adjust and revise valuation parameters.

You should not only consider the financial status, product structure,
and business structure but also consider industry trends and
company strategy to come to a comprehensive understanding of
the company being valued.

Key Learning Points

• A DCF model is built using the income statement, balance sheet,

and cash flow statement.

• The model assumes that the company faces a relatively complete

market environment, that is, the institutional environment and the
operating environment are stable, the company continues to
operate, and investors have rational and consistent expectations.

• The DCF is based on assuming that the business is a going concern,

meaning that it is expected to continue operations for the
foreseeable future.

• DCF analysis is an important and widely used tool for valuation in

equity research and corporate finance.

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