What Does Discounted Cash Flow (DCF) Mean?
The discounted cash flow approach (DCF) is one of three business valuation approaches based on future earnings. The other two are the capitalization of earnings and capitalization of cash flow approaches. You would use the discounted cash flow approach when a 3 to 5 year cash flow projection can be computed, or there are uneven capital expenditures over the time period. It is the preferred method of valuation professionals and entails the following three steps:
- Calculate the present value of free cash flows for a specific projection period;
- Calculate the terminal value after the projection period and present value it; and
- Estimate the equity value after consideration for redundant assets and debt.
Divestopedia Explains Discounted Cash Flow (DCF)
When estimating the present value of annual cash flow, it is best to start with a 3-5 year projection that takes the numbers to the pre-tax EBITDA line. At this point, EBITDA can be tax effected and then sustaining or growth capital expenditures and changes in working capital cash requirements should be deducted to determine the operating cash flow. The discount factor in the present value calculation used is the company's weighted average cost of capital (WACC).
After the projection period, it is assumed that cash flow stabilizes into perpetuity. 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. 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.
Once the present value of the projected 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. 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.