Introduction to Discounted Cash Flow Analysis

Discounted Cash Flow Analysis or DCF is rather important. 

It may value any company. 

It requires only projected cash flows and assessment of risk. 

DCF is the present value of an asset’s future cash flows discounted on the risk of those cash flows. Discounted cash flow (DCF) analysis uses future (free) cash flows (projections) and brings them to the present: by discounting the expected incoming cash using a discount rate (most often using the weighted average cost of capital) to arrive at a present value.

Following is an illustration.

 

Outline

Step 1: Determine the key metrics for the corporation

Step 2: Calculate proforma or projected un-levered Free Cash Flow ( Un-levered FCF)

Step 2: Calculate Weighted Average Cost of Capital (WACC)

Step 3: Calculate Terminal value based on projected un-levered free cash.

Step 4: Calculate Enterprise Value (or approximate value of the corporation) 

A more detailed outline of steps is:

1.    Develop baseline financial projections (pro forma report)
2.    From projections calculate unlevered free cash flow
3.    Calculate weighted average cost of capital
4.    Discount the unlevered free cash flow to their present value
5.    Calculate terminal value
6.    Discount the terminal value to its present value
7.    Present value of unlevered cash flow + Present value of terminal value
8.    Adjust total present value to reflect other assets and liabilities
9.    Subtract net debt and preferred stock -> value for common equity
10.    Divide equity value by (diluted) shares to arrive at an equity value per share
11.    Engage in sensitivity analysis to provide a valuation range
12.    Review analysis and draw conclusions

Step 1: Calculate Unlevered Free Cash Flow

Free cash flow is cash flow removed from any judgement calls like depreciation or even receivables and payables. We use unlevered free cash flow in Discounted Free Cash Flow because unlevered free cash flow is free cash flow before accounting for interest or dividends. 

 

A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt. 

 FCF =EBIT (1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

EBIT = Revenues (or sales) – COGS – SG&A –DD&A 

Net Working Capital  = Cash + Accounts Receivables + Inventories – Accounts Payable – Other Accrued Expenses.
Change in Net Working Capital = New Net Working Capital - Previous Net Working Capital