Discounted Cash Flow (DCF) Method- Rationale
What is Discounted Cash Flow (DCF)? DCF Explained.
Discounted Cash Flow (DCF) analysis is a method of valuing a pre-revenue startup using the concepts of the time value of money. All future cash flows are estimated and discounted by using a cost of capital to give their present values (PVs). The income approach recognizes that the value of an investment is premised on the receipt of future economic benefits. These benefits can include earnings, cost savings, tax deductions and the proceeds from disposition. Discounted Cash Flow Method is a form of the income approach that is commonly used to value businesses or equity interests.
In this method, the appraiser estimates the cash flows of any business, after all operating expenses, taxes, and necessary investments in working capital and capital expenditure is being met. Valuing equity using the free cash flow to stockholders requires estimating only free cash flow to equity holders after debt holders have been paid off. This method is more appropriate when future returns are expected to be substantially different from current operations. This method usually has two stages, the first stage involves a discreet forecast of future earnings or cash flow to be discounted to the present using a discount rate and the second stage involves the construction and discounting of a terminal value. The terminal value is determined when the entity’s future return stream is expected to achieve stable long-term growth.
PV of future sum = FV/(1+r)n
The rationale for Selecting DCF Method.
Why should we select the DCF method for business valuation?
- Under a DCF approach, forecast cash flows are discounted back to the present date, generating a net present value for the cash flow stream of the business. A terminal value at the end of the explicit forecast period is then determined and that value is also discounted back to the valuation date to give an overall value for the business.
- A Discounted cash flow methodology typically requires the forecast period to be of such a length to enable the business to achieve a stabilized level of earnings or to be reflective of an entire operation cycle for more cyclical industries.
- The rate at which the future cash flows are discounted (“the discount rate”) should reflect not only the time value of money but also the risk associated with the business’s future operations. The discount rate most generally employed is Cost of Equity (“COE”).
- In calculating the terminal value, regard must be had to the business’ potential for further growth beyond the explicit forecast period. The “constant growth model”, which applies an expected constant level of growth to the cash flow forecast in the last year of the forecast period and assumes such growth is achieved in perpetuity, is a common method. These results would be cross-checked, however, for reasonability to implied exit multiples.
- The rate at which future cash flows are discounted should reflect not only the time value of the cash flows but also the risk associated with the business’s future operations. This means that in order for a DCF to produce a sensible valuation figure, the importance of the quality of the underlying cash flow forecasts is fundamental.
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