A Comprehensive Guide on DCF Financial Modeling

September 12, 2023 Darsana Sudarsanan A Financial Modeling, Review

Discounted cash flow DCF calculation decides the current value of a business or investment based on the value of the cash it can make hereafter. The belief is that the business or asset is predicted to develop cash flows. In finance, it is employed to represent the amount of cash in this period. Discounted cash flow (DCF) allows for defining the value of an investment based on its prospective cash flows. If the DCF is beyond the current cost of the investment, the possibility could result in favorable returns. These reasons explain the importance of DCF financial modeling.

What is a DCF Model?

In DCF Financial modeling, a DCF model is a detailed financial modeling tool employed to value a company. DCF implies Discounted Cash Flow and is a projection of a business’s unlevered free cash flow discounted around today’s value known as Net Present Value(NPV).

What is Unlevered Free Cash Flow in DCF Financial Modeling?

Cash flow is only the money generated by a business that’s open to being reinvested in the company or allocated to investors. Unlevered Free Cash Flow (also named Free Cash Flow to the Firm) – is cash unrestricted to debt and equity investors.

We use Cashflow because it represents the economic value when accounting metrics such as net income do not. A firm may have positive net earnings but negative cash flow, which would damage the industry economics.

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Why is the Cash Flow Discounted in DCF Financial Modeling?

The cash flow developed from the business is discounted back to a precise point in time, typically to the current date. The reasons for cash flow discounting are outlined as opportunity cost and risk by the idea of the time value of cash. The time value of capital believes that present money is worth more than future money because you can fund and earn more with the money in the present.

A company’s Weighted Average Cost of Capital (WACC) describes the necessary rate of return hoped by its investors. Thus, it is also a firm’s opportunity cost, indicating if they can’t see a higher rate of return elsewhere, they should purchase back their shares.

As long as a company gains rates of return exceeding its cost of capital ( hurdle rate), they are “creating value.” Achieving a rate of return less than their cost of capital is “destroying value.”

Investors’ critical rate of return typically relates to the investment risk (employing the Capital Asset Pricing Model). Thus, the riskier an asset, the higher the needed rate of return and the more increased the cost of capital.

The overtop the cash flows are, the more difficult they are, and, thus, they develop the condition for more discounts.

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What is the Forecast Period in DCF Financial Modeling?

In corporate finance, concerning discounted cash flow valuation, the forecast period is when we put in particular yearly cash flows to the valuation formula. A fixed number or the terminal value means cash flows following the forecast period. This number is specified using beliefs connecting to the sustainable compound yearly growth rate or exit multiple.

There are no set rules for deciding the span of the forecast period. However, selecting a forecast period of ten years will not be significant when we can model unique cash flows simply for four years. Hence the “meaningfulness” of the particular annual cash flows ahead restricts the number of forecasting years. Thus, there are three standard methods of defining the forecast period.

Based on Company Positioning:

The forecast period corresponds to the years where an additional return is likely. In the selected time, the business should expect to develop a return on recent investments greater than its price of capital. This will rely on its predicted competitiveness, coupled with general barriers to entry.

Based on Exit Strategy:

It is the number of years preceding the planning of an exit. An exit can be favorable (merger, initial public offering, acquisition) or negative (bankruptcy). Investors typically use this process in venture private equity and capital, preparing for a positive exit.

Based on Market Characteristics:

Select a forecast period by choosing several years based on the features of the market. Companies in well-known and established markets are better suited for more protracted forecasting periods than those introducing a new market or startups.

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What Is Terminal Value Discussed in DCF Financial Modeling?

Terminal value (TV) is the value of an investment, company, or project further the forecasted period when we can calculate future cash flows. Terminal value thinks a business will continue to grow at a set growth rate after the forecast period. Terminal value usually includes a significant part of the total assessed value.

Terminal value (TV) decides a company’s value into continuance past a set forecast period—usually five years. Analysts employ the discounted cash flow model (DCF) to calculate the total value of a business. The forecast period and terminal value are both critical elements of DCF.

The two most standard methods for calculating terminal value are perpetual growth and exit multiple. The perpetual growth method is also named Gordon Growth Model. It believes that a company will develop cash flows at a steady rate forever, while the exit multiple methods assume that the sale of the company would happen.

Forecasting gets darker as the time horizon extends longer. This holds in finance, particularly while evaluating a company’s cash flows well into the future. At the same time, companies ought to be valued. To “solve” this, analysts employ financial models, like discounted cash flow (DCF), along with specific assumptions to emanate the total value of a company or project.

Discounted cash flow (DCF) is a widespread method employed in feasibility studies, stock market valuation, and corporate acquisitions. The theory that an investment’s value is identical to all future cash flows emanating from that investment forms the basis of this method. It is required to discount these cash flows to the current value at a discount rate denoting the cost of capital, like the interest rate.

DCF has two main components: forecast period & terminal value. The forecast period is typically about five years. Anything more prolonged than that and the precision of the projections suffer, making terminal value calculations significant.

There are two generally used methods to estimate terminal value: perpetual growth (Gordon Growth Model) and exit multiple. The former believes that a firm will continue generating cash flows at a steady rate, while the latter assumes that a company’s sale occurs for a multiple of some market metric. Investment professionals like the exit multiple methods, while academics prefer the perpetual growth standard.

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Steps in DCF financial Modeling

The DCF financial modeling assumes that the value of a company is purely a process of its future cash flows. Thus, the foremost challenge in DCF Financial modeling is defining and calculating business-generated cash flows. There are two standard methods for estimating cash flow developed in a company.

Unlevered DCF Approach:

Predict and discount the operating cash flows. Then, when you own a present value, add any non-operating investments like cash and deduct any financing-related liabilities such as debt.

Levered DCF Approach:

Forecast and discount the cash flows remaining functional to equity shareholders after withdrawing cash flows to all non-equity claims (debt). Both should theoretically guide to the exact value at the end (though basically, it’s pretty complex to get them equal). The unlevered DCF method is the most familiar approach. This approach includes six steps. They are:

Predicting Unlevered Free Cash Flows:

The primary step is to predict the cash flows a business develops from its core functions after accounting for the entire operational costs and investments. These cash flows are named “unlevered free cash flows.”

Calculating Terminal Value:

You can’t continue forecasting cash flows forever. You will have to make some high-level assumptions about cash flows beyond the final explicit forecast year by estimating a lump-sum value of the business past its detailed forecast period. That single sum is named the “terminal value.”

Discounting the Cash Flows to the Current Times at the Weighted Intermediate Cost of Capital:

The discount rate that mirrors the liability of the unlevered free cash flows is dubbed the weighted average cost of capital. Since unlevered free cash flows denote all operational cash flows, these cash flows “belong” to both the firm’s lenders and landlords. As such, we should record the risks of both capital providers for utilizing proper capital structure weights (thus the term “weighted average” capital cost). Once discounted, the current value of all unlevered free cash flows is named the enterprise value.

Count the Value of Non-operating Investments to the Current Value of Unlevered Free Cash Flows:

If a business holds any non-operating assets like cash or has some investments remaining on the balance sheet, we must count them to the current value of unlevered free cash flows.

Deduct Debt and Different Non-equity Claims:

The foremost goal of the DCF is to get at what applies to the equity owners (equity value). Thus if a company includes any lenders (or any further non-equity claims against the company), we should deduct this from the current value. What’s remaining belongs to the equity owners.

Usually, the debt claims and non-operating assets are counted jointly as one term dubbed net debt. You’ll often notice the equation: enterprise value – net debt = equity value. The equity value that the DCF spits out is thus comparable to the market capitalization (that’s the market’s idea of the equity value).

Split the Equity Value by the Stakes Outstanding:

The equity value informs us what the total value to proprietors is. But to estimate the value of the individual share, we split the equity value by the firm’s diluted shares outstanding.

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Benefits of a Discounted Cash Flow Analysis in DCF Financial Modeling:

The primary advantage of a discounted cash flow analysis is its usage of precise numbers and more objectivity than other approaches to value

an asset.

Here Are Some Other Benefits of a Discounted Cash Flow Analysis:

Extremely Detailed:

It employs specific numbers that have significant assumptions about a company, involving cash flow projections, growth rate, and other measures to reach a value.

Defines the “Intrinsic” Value of a Company:

It estimates value besides subjective market sentiment and is more objective than other methods.

Doesn’t Require to Use of Comparables:

DCF analysis does not need market value comparisons to similar firms.

Examines Long-Term Values:

It considers the revenues of an undertaking or investment over its whole economic life and regards the time value of money.

Allows Objective Comparison:

DCF analysis lets you analyze different types of businesses or investments and reach an objective and even valuation for all of them.

Can Be Completed in Excel:

While specialized software can assist you in performing a discounted cash flow analysis, you can also complete the study by employing an Excel spreadsheet.

Fit for Acquisitions and Analyzing Mergers:

The objectivity provided by discounted cash flow analysis allows company leaders to judge whether a business should acquire or merge with another company.

Computes Internal Rate of Return:

Completing discounted cash flow analysis can assist companies in calculating the internal rate of return (IRR) on assets, permitting them to liken the value of competing assets.

Permits Sensitivity Analysis:

The discounted cash flow model allows experts to consider how changes in their deductions of an investment would impact the final value the model delivers. Those varying assumptions might contain discount rate or the cash flow growth fixed to investing.

You can employ a template to notice how differences in the discount rate or the projected growth rate in a discounted cash flow calculation would impact the value of the initial analysis you estimated for the asset.

Disadvantages of a Discounted Cash Flow Analysis

A discounted cash flow analysis also has limits, as it needs you to manage a significant amount of data and depends on deductions that can, in some circumstances, be wrong.

Here Are the Chief Limitations or Disadvantages of a Discounted Cash Flow Analysis:

Needs Significant Data, Like Data on Expenses and Projected Revenue: Completing a discounted cash flow analysis demands a significant amount of financial data, like capital expenditure over many years and forecasts for cash flow. Some investors might see it is hard to collect the needed data; even simple procedures take some time.
Sensitive to the Projections It Depends On: The analysis is responsive to its variables, including the asset’s perpetual growth rate, forecasts of future cash flow, and the discount rate that professionals believe is good for the investment.
Analysis Relies on Accurate Estimates: A discounted cash flow estimation is only as good as the estimates and projections it uses.
Depends on Confidence in Future Cash Flows: Because projections and deductions must be precise to deliver reliable valuations, the analysis functions best when you maintain high confidence in an asset’s future cash flows.
Prone to Intricacy: Because of the data required for the discounted cash flow procedures, the study can become complex.
Doesn’t Assume Valuations of Competitors: An benefit of discounted cash flow — that it doesn’t require considering competitor’s value — can also be a weakness. Ultimately, DCF can make valuations far from the true value of competitor firms or comparable investments. That might suggest those other business values are false — but it might also indicate the discounted cash flow analysis is not assuming market facts and is itself wrong.
The Terminal Value Challenge- An significant portion of the discounted cash flow formula is the terminal value of the asset, which is the current value of a business or acquisition after the multi-year projection period. That terminal value might mean assumed cash flow in all coming years past the forecast period or the full value of the business or investment if it were sold at the end of the forecast period. Either way, the terminal value is challenging to evaluate. And it develops a large part of the total value that the discounted cash flow formula creates.
Problems with Weighted Average Cost of Capital: The discounted cash flow study also employs the subject firm’s weighted average cost of capital (WACC), which describes the firm’s cost of capital from all its bases, as part of its procedure. It can be a challenging number to accurately estimate.
Not Proficient at Evaluating Starkly Distinct Types of Investments: Discounted cash flow can consider widely variable types of investments as long as they all hold relatively predictable cash flow. But it is not as proficient at evaluating investments of considerably different sizes, with very disparate cash flow predictions, or with changing beliefs in those projections.

Frequently Asked Questions:

Q. What is a DCF financial model?

A DCF model is a distinct financial modeling device used to value a company. DCF means Discounted Cash Flow, so a DCF model is only a projection of a firm’s unlevered free cash flow discounted around today’s worth, called the Net Present Value (NPV).

Q. Is NPV the same as DCF?

The NPV approximates the value of the asset amount today to its value hereafter, while the DCF assists in studying an asset and determining its value—and how helpful it would be—tomorrow.

Q. How do you forecast revenue growth in DCF?

The most effortless way to estimate growth is to deduct the beginning worth from its ending value, and then divide that outcome by the beginning value.

Conclusion:

The DCF financial modeling is just as helpful as the deductions that analysts can include. Analysts usually spend significant time accomplishing the “plumbing” for their models: that is, managing the projects, making them active, performing sensitivity analysis, etc. Failure to dedicate adequate concentration to making precise projections will result in an incomplete valuation, regardless of the additional “bells and whistles” that we include. Thriving analyses result from spending enough time confirming that the projected values are correct and comprehensive.

We hope the article helped you get a fundamental understanding of the concept of DCF financial modeling. Let us know through your comments. Happy Learning