Discounted Cash Flow (DCF)
- Discounted Cash Flow (DCF): A DCF model is a crucial tool in financial valuation. It estimates the present value of a company by projecting all its expected future cash flows. These cash flows are then 'discounted' back to the present using a 'discount rate'. The core principle behind DCF is the time value of money - a dollar today is worth more than a dollar in the future.
- Reason for DCF Usage: The DCF method stands out for its ability to consider the time value of money and provide a detailed, forward-looking perspective into a company's financial performance. However, this method isn't perfect. It relies heavily on assumptions about future performance and the state of the economy, making it somewhat subjective and open to interpretation.
- Forecasting Future Free Cash Flows (FCF): In a DCF model, we start by estimating the company's future free cash flows. This is typically done using a formula that considers Earnings Before Interest and Taxes (EBIT), Tax Rate, Depreciation & Amortization (D&A), Capital Expenditures (CapEX), and changes in net working capital. Predicting these future FCFs involves a deep understanding of the company's current financial situation and a detailed analysis of past performance trends.
- Calculating Terminal Value (TV): TV is a critical component of a DCF analysis. It accounts for all the future cash flows beyond the explicit forecast period (usually 5-10 years). Two common methods of estimating TV are the Gordon Growth Method, which assumes a company will grow at a constant rate indefinitely, and the Exit Multiple Method, which applies a multiple to a company's final year EBITDA, based on comparable companies.
- Weighted Average Cost of Capital (WACC): WACC is the average rate a company is expected to pay to finance its assets. It blends the cost of equity and the cost of debt, weighted by their proportions in the company's capital structure. WACC is essential in DCF analysis as it acts as the 'discount rate', indicating the return expected by investors.
- Cost of Equity: This is the return that a company's shareholders require as compensation for their investment risk. The Capital Asset Pricing Model (CAPM) is typically used to estimate the cost of equity, considering factors such as the risk-free rate (usually based on government bond yields), the company's beta (a measure of its stock's volatility), and the equity risk premium (the excess return expected from the stock market over the risk-free rate).
- Cost of Debt: Cost of debt is the effective interest rate a company pays on its debts. It's calculated in several ways, including adding a default spread to the risk-free rate, dividing total interest expense by total debt, or using the average Yield to Maturity (YTM) of a company's debt. This is a crucial element of the WACC.
- Enterprise Value (EV): EV reflects a company's total market value, inclusive of equity, debt, and other financial commitments. In a DCF analysis, EV is calculated by taking the present value of future free cash flows and adding the present value of the Terminal Value.
- Equity Value: Also known as market value, equity value is derived from EV by subtracting any debt and other obligations. It represents the portion of a company's value that can be claimed by equity shareholders.
- Share Price: The final step in a DCF model is to calculate the theoretical share price. This is done by dividing the Equity Value by the total number of shares outstanding. It gives a per-share value that can be compared to the current market price to identify overvalued or undervalued stocks.
- Sensitivity Analysis: This is a technique used to understand the effect of changing key inputs and assumptions on the DCF outcome. By varying important parameters such as the growth rate or WACC, you can estimate a range of potential outcomes and understand the model's robustness. This is essential in financial modeling given the inherent uncertainties in predicting future cash flows and the potential impact of unexpected events.