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Discounted cash flow valuation: determining intrinsic value through future cash flow analysis

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The discounted cash flow (DCF) valuation method estimates the intrinsic value of a business or project by forecasting future cash flows and discounting them back to their present value using an appropriate discount rate.

It is a cornerstone technique in corporate finance because it directly links valuation to the entity’s capacity to generate cash, rather than relying solely on market multiples or historical cost measures.



The logic behind DCF valuation.

The principle of DCF is that a dollar today is worth more than a dollar tomorrow, due to the opportunity cost of capital and the risks associated with future cash flows.

By discounting expected free cash flows (FCF)—the cash available to all capital providers after necessary reinvestments—DCF produces a present value that reflects both the magnitude and timing of those cash flows.

Concept

Definition

Free Cash Flow (FCF)

Operating cash flow minus capital expenditures and changes in working capital

Discount Rate

The required rate of return, often the company’s WACC

Terminal Value (TV)

The estimated value of cash flows beyond the explicit forecast period



Steps in conducting a DCF valuation.

  1. Forecast free cash flows for a defined projection period, typically 5–10 years.

    Example: FCF = EBIT × (1 − Tax rate) + Depreciation & Amortization − CapEx − Change in Working Capital.

  2. Determine the discount rate, usually WACC for firm valuation or cost of equity for equity valuation.

  3. Estimate terminal value using either:

    - Gordon Growth Model: TV = Final year FCF × (1 + g) / (r − g)

    - Exit multiple method: Apply a market-based multiple to the final year’s EBITDA or earnings.

  4. Discount the cash flows and terminal value to present value.

  5. Sum the present values to determine enterprise value (EV).

  6. Adjust for net debt (Debt − Cash) to derive equity value.



Example of a simplified DCF calculation.

Year

Forecast FCF ($m)

Discount Factor @ 9%

Present Value ($m)

1

50

0.9174

45.87

2

55

0.8417

46.29

3

60

0.7722

46.33

4

65

0.7084

46.05

5

70

0.6499

45.49

TV

1,050

0.6499

682.39

Enterprise Value = $912.42m

If net debt is $200m, Equity Value = $712.42m.



Advantages of the DCF approach.

  • Cash flow focus: Directly tied to the company’s ability to generate cash, which drives long-term value.

  • Flexibility: Can incorporate detailed assumptions about growth, margins, and capital requirements.

  • Forward-looking: Unlike multiples, does not depend on market sentiment or peer performance.


Limitations and sensitivities in DCF valuation.

  • Forecasting risk: Small errors in revenue, margin, or capital expenditure assumptions can significantly impact value.

  • Discount rate sensitivity: A 1% change in WACC can alter valuation materially.

  • Terminal value dominance: Often constitutes the majority of total value, making long-term assumptions critical.

Variable

Impact if Higher

Revenue growth rate

↑ Enterprise Value

Discount rate (WACC)

↓ Enterprise Value

Terminal growth rate

↑ Enterprise Value (if sustainable)



Best practice in applying DCF valuation.

  • Use scenario and sensitivity analysis to understand how valuation changes under different assumptions.

  • Cross-check results against market multiples and other valuation methods.

  • Align assumptions with industry trends, macroeconomic forecasts, and company strategy.


Under US GAAP and IFRS, DCF is widely used in impairment testing for goodwill and long-lived assets, fair value measurements, and internal investment appraisals.Its strength lies in translating strategic forecasts into a present-day monetary value, making it indispensable for investment bankers, corporate strategists, and financial analysts alike.



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