Discounted Cash Flow (DCF)

Discounted Cash Flow (DCF) modelling is one of the most widely used methods for valuing companies, as it provides an estimate of the company’s intrinsic value based on its future cash flow projections. While we previously discussed the DCF analysis setup, this chapter will focus on the practical implementation of a DCF model in valuing a company, providing an in-depth example to demonstrate the entire process.

Overview of DCF Modeling for Valuation

In DCF modelling, the value of a company is calculated by forecasting its future free cash flows (FCFs) and then discounting them back to the present value using a discount rate, typically the company’s Weighted Average Cost of Capital (WACC). The model also accounts for the Terminal Value (TV), which captures the company's value beyond the forecasted period.

Key Components:

1. Forecasting Free Cash Flow (FCF)
   

2. Choosing a Discount Rate (WACC)
   

3. Calculating Terminal Value (TV)
   

4. Summing the Present Values of FCF and TV
   

Step-by-Step Guide: Practical Example of DCF Modeling

Step 1: Forecast Free Cash Flows (FCF)

Let’s assume we are valuing a company with the following projected financials for the next five years. Free cash flow is calculated as: FCF = Operating Cash Flows - Capital Expenditures

Step 2: Choose a Discount Rate (WACC)

The discount rate typically used in DCF modelling is the Weighted Average Cost of Capital (WACC), which reflects the company’s cost of equity and debt.

Let’s assume the WACC for this company is 10%.

Step 3: Calculate Terminal Value (TV)

To capture the company's value beyond the forecast period, we calculate the terminal value using the Gordon Growth Model:

TV = FCF__(n+1) / (WACC - g)

Where:

• FCFₙ₊₁ = Free cash flow in the year after the forecast period (2029).
  

• g =Long-term growth rate (let’s assume 3%).
  

First, calculate the FCF in 2029 by assuming it grows at the long-term rate:

FCF₍₂₀₂₉₎ = FCF₍₂₀₂₈₎× (1 + g) = 18M × (1 + 0.03) = 18.54M

Now, calculate the terminal value:

TV = 18.54M / (0.10 - 0.03) = 264.86M

Step 4: Calculate the Present Value of Free Cash Flows and Terminal Value

Now, we will discount the FCFs and terminal value back to their present value using the WACC of 10%.

PV = FCFₜ / (1 + WACC)^t

Now, for the terminal value:

PV₍TV₎ = 264.86M / (1 + 0.10)^5 = 164.47M

Step 5: Sum the Present Values

To arrive at the enterprise value (EV) of the company, sum the present values of all FCFs and the terminal value:

EV = 9.09M + 9.91M + 11.27M + 11.61M + 11.18M + 164.47M = 217.53M

Thus, the company's estimated enterprise value using the DCF model is ₹217.53 million.

Key Assumptions in DCF Valuation

1. Revenue Growth: Assumed based on historical trends or market analysis.
   

2. WACC: Reflects the company's risk and capital structure.
   

3. Terminal Growth Rate (g): Should be conservative, typically in line with GDP growth.
   

4. Capital Expenditures: Projected based on the company’s future investment needs.
   

Key Takeaways:

• DCF modelling requires careful forecasting of free cash flows and an appropriate discount rate.
  

• The Terminal Value is crucial, as it often represents the majority of a company’s valuation.
  

• A company's enterprise value is the sum of discounted cash flows and the discounted terminal value.
  

Conclusion:

DCF modelling is a powerful tool for valuing companies, offering an intrinsic value based on future cash flow projections. While assumptions in the model are critical, they provide a clear framework for assessing investment opportunities and company valuations.

Next Chapter Preview: In the next chapter, we will explore Building a Sensitivity Analysis Model in Excel, where we will analyse how changes in key assumptions such as growth rates, WACC, or terminal value affect the overall valuation. Stay tuned for detailed insights into performing sensitivity analysis to assess risk and uncertainty in financial models!