In this blog, we will learn about one of the key models in finance called Discounted Cash Flow Model. We are continuously working to bring relevant materials for you to improve your knowledge in the field of finance and accounting and help you excel in your academics. If you are struggling with your finance assignment, ask us to help you in Finance Assignment Help and our expert will deliver you a well-documented solution within reasonable prices.
DCF model is a financial model that forecasts the company’s free cash flow and discount back to the present time which is called NPV to value a business. It considers that a company’s value can be calculated from its cash flow generating abilities, not on the demand and supply of its stock price. This concept helps in determining the intrinsic value of the stock and is used for comparing it with its market price so that stock can be determined as overpriced or undervalued.
The main part of the DCF model is linking of its three financial statements, before calculating the un-levered cash flow and making other adjustments for valuation, we to have forecast the financial statements for specific years based on certain assumptions. An analyst used to forecast numbers for 5 years but it is different in the case of valuing startups, mining, and oil exploring companies, etc. An analyst determines the assumptions for forecasting revenue, expenses, capital assets and capital structure of the company and these are as follows:
- Forecasting revenue - There are mainly two ways of forecast: growth-based and driver-based. In growth-based method revenue is calculated from past revenue growth, it is simple and used in the case of stable business while the driver-based forecast is complicated which requires drivers like sales volume, price of the product, customer, market share, and other factors.
- Forecasting expenses - Generally major expenses are dependent on the revenue that the company wants to generate like the cost of goods sold, selling, general, and administrative expenses so as revenue increases theses expenses are also increasing and vice-versa. The analyst usually follows the past trends or year wise comparison for calculating these expenses. Non-cash operating expenses like depreciation and amortization are calculated differently based on the method followed by the company as a percent of PP&E and intangible assets.
- Forecasting capital assets – These include balance sheet items such as property plant and equipment (PP&E), intangible assets, and working capital including stock and Debtors. Generally, PP&E is the largest line item in the balance sheet so analysts use to prepare a separate schedule to calculate capital expenditure and depreciation and disposition of assets during the year.
- Forecasting capital structure – This section largely depends on the type of DCF model you are building. Commonly it is assumed that there will be no change in capital structure through-out its existence except the known things like the maturity of the debt. It is not important if you are looking at things from the perspective of an investment banker who typically focuses on enterprise value, where an entire company is valued. When an investor or equity research analyst performs DCF analysis then free cash flow to equity is calculated while considering the debt issuance and debt payment.
After forecasting all three financial statements, calculate free cash to the firm or free cash flow to equity as per the required valuation. These can be calculated using formulas
Cash flow to firm = EBIT + Depreciation & Amortization + Changes in working Capital – Capital expenditure
Cash flow to equity = Cash flow from operations (from cash flow) – capital expenditure + debt issuance (less payment)
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In DCF we calculate free cash flow for certain years that usually includes two-year actual numbers and five year estimated numbers. But for valuing the company we need to calculate company’s entire cash flow till the company is going to exist, for that we need to calculate the terminal value which often contributes more than 50% of the enterprise value. Terminal value can be calculated from the two available methods: perpetual growth method and exit multiple-method.
Under perpetual growth, it has assumed that cash flow generated at the end of the forecast year will grow at a constant rate forever. For example, the cash flow of the firm is $5 Million at a growth rate of 2% with a cost of capital of 10%. Then terminal value is $5(1+2%)/(10% -2%) = $63.75 Million. The exit multiple-method under which business assumes to be sold and what a reasonable buyer pays for it and which is EV/EBITDA multiple of trading comparable companies. For example, if similar companies are trading at 5x and the company’s EBITDA is $5 million then the terminal value will be $25 million.
DCF Enterprise Value
When we discount all the free cash flows and its terminal value at the rate of the cost of capital, we came up with the present value of the firm which is EV. It is an entire value of the firm without considering its cash and debt equivalents. In excel we can use the formula XNPV for the net present value of cash flows. In case if you are looking for equity value you can use the formula as follows:
Equity value = Enterprise value + Cash & Cash Equivalents– Debt – Minority interest
I hope this blog has helped you understand the concept of a discounted cash flow model. Our finance/accounting experts are highly knowledgeable and have professional skills to assist you in your Accounting Assignment Help. Feel free to contact us anytime at writemyassignmentus.com with your problem. We will deliver you the solution within the deadline.