Discounted Cash FlowThe discounted cash flow method (DCF) is one of the three primary future earnings business valuation methods. business valuation methods. You would use the discounted cash flow method when a 3 to 5 year cash flow projection can be computed, and there are uneven capital expenditures over the time period. It is the preferred method of valuation professionals, so we will provide here some guidelines to help you understand how it works.
The method involves essentially the following three steps:
- Calculating the present value of free cash flows for a specific projection period;
- Calculating the present value of terminal value after the projection period; and
- Estimating Equity Value After Considerations for Redundant Assets and Debt.
CALCULATING THE PRESENT VALUE OF FREE CASH FLOW FOR A SPECIFIC PERIODA 3 to 5 year projection is critical when conducting a discounted cash flow analysis. The better the assumptions are that go into the projection, the more accurate the final value will be. The projection typically starts with computing normalized and recurring earnings before income taxes and depreciation or (EBITDA). The key assumptions to consider include pricing sensitivity, competition, how elastic demand is for the products and services, operating costs, and production capacity. You also need to think about the growth factor you need to use, and whether or not inflation is factored into the growth factor. In addition, EBITDA needs to be normalized for any one time, non recurring revenues or expenses that do not recur in the future.
Upon calculating the normalized EBITDA for the 5 year projection, an effective tax rate would be applied to these figures. The after tax EBITDA is essentially a proxy for after tax operating cash flow.
At this point, it is critical to estimate the balance sheet impact of this projection beyond what operating cash flow is. Since the business is assumed to be in growth mode, there would be capital expenditures both to sustain the current business but also to grow the business. Therefore, both sustaining and growth capex need to be subtracted from operating cash flow making sure they are net of the present value of any tax shield available (if the company resides in a jurisdiction that provides for a tax shield). As well, the incremental net working capital needs of the business would have to be subtracted from the operating cash flow to allow for a growing revenue projection. As revenue increases, accounts receivable increase too which is not immediate cash generated. Therefore, this accounts receivable build-up needs to be subtracted from operating cash flow to determine the free cash flow during the projection period.
CALCULATING THE PRESENT VALUE OF TERMINAL VALUE AFTER THE PROJECTION PERIODAfter the projection period, it is assumed that cash flow stabilizes into perpetuity. At this point, the calculation is not that different than what happens during the projection period. The normalized, perpetual after-tax EBITDA would be computed (typically as a range) and all sustaining capex going forward would be subtracted. We assume at this point that net working capital has stabilized, so there is no addition or subtraction for net working capital.
The key here is to take the perpetual after-tax cash flow calculated above, and then apply the correct multiple to it to drive the terminal value. The multiple is the inverse of the capitalization rate. The capitalization rate and also the discount rate are derived from the company’s weighted average cost of capital ("WACC").
ESTIMATING THE EQUITY VALUE AFTER CONSIDERATIONS FOR REDUNDANT ASSETS AND DEBTOnce the present value of the projection cash flows and the terminal value have been calculated, the discounted cash flow calculation is almost complete. At this point, all redundant assets should be added back to the discounted cash flow value. Redundant assets are those assets that are not required to run the business under normal circumstances. For example, a certain level of working capital would be required to operate a business. Any excess over this threshold would be considered redundant and would be added separately to the valuation to determine enterprise value. The enterprise value of the business is therefore the present value of all of its cash flow plus any redundant assets. Since we have assumed all along a valuation that does not incorporate debt, we would then subtract all interest bearing debt from the calculated enterprise value to deliver the equity value of the business. This is the final result you are after as this calculated equity value (which is usually represented as a range) would then be divided by the total outstanding number of shares to compute the equity value per share.
The discounted cash flow approach is the preferred business valuation method for companies. It is advisable that at least once a year, a brief DCF valuation be conducted to determine where value is at and how the business is tracking to its projections.