What is DCF Valuation?
It is an advanced valuation method in which the worth of the entity or firm is the value of this cash flow. The sum total of discounted future payments that represent different levels of revenue in future periods, such as revenue at year 10, are what makes up the DCF valuation. The DCF methodology employed by Fintalent’s DCF Valuation consultants calculates expected net cash flows and then discounts them back to their present value using either a constant rate or one with some variability depending on the risk associated with each future payment.
The discounted cash flow formula goes as follows:
DCF=(CF1+CF2+CF3+etc.+CFn)/(r-g), where DCF is the discounted cash flow, CFn is the last cash flow in time, r and g are the discounting rate and growth rate respectively.
For companies with stable cash flow and slow growing revenues, a DCF valuation is ideal if they do not have a large debt present on their balance sheets. The DCF formula is used to calculate the sum of discounted free cash flows. As mentioned before, these are essentially all of the different payments made throughout future periods from initial investment to exit of that investment by either company or shareholder, that would be considered profit to that recipient (investor).
DCF valuation is a more accurate and conservative method of valuing a company if the company has stable cash flow and slow growth rates because it does not use current cash flow to value the company but rather future expected cash flows. It is also advantageous because it can show where inefficiencies lie, and therefore where value can be added through strategic change that would be missed with other methods.
An example of an inefficiency could be that an entity has high turnover with minimal profit margins. This could mean they are overstaffed, or have other inefficiencies built within their company. A DCF valuation would show the company could have a higher profit margin if it were to change something in the way they staff the business.
An example of a strategic issue could be that the growth rates are slow, but projected future growth is extremely high. This could mean there is not enough capital for expansion, or that inefficiencies exist within their operations that would reduce earnings if left unfixed.
DCF valuation can be used by investors when making decisions on reinvestment of dividends and future share purchases, which are key to capital return management.
DCF Valuation is also a useful tool for the company in analyzing the worth of the company itself. It can be used to find and fix any inefficiencies within their current state, and ensure a higher return from profit going forward to help ensure the long-term viability of the firm.
The discount rates have to be weighted as different cash flows have different risk levels. The discount rates vary from each other based on their varying level of risk. The rate is computed by multiplying all expected future cash flows with the probability weighted discounting rate.
The DCF formula looks as follows:
DCF=(CF1+CF2+CF3+etc.+CFn)/(r-g), where DCF is the discounted cash flow, CFN is the last cash flow in time, r and g are the discounting rate and growth rate respectively.
The DCF formula can be compounded either by a constant or variable rate. The Constant Rate of Return with a CAGR of 7% is the most used option for the forecast. It has been used by companies and investors when delving into the DCF valuation for the first time. The formula is as follows:
DCF=(CF1+CF2+CF3+etc.+CFn)/(r-g), where DCF is the discounted cash flow, CFN is the last cash flow in time, r and g are the discounting rate and growth rate respectively.
The below is an example of a DCF valuation that takes into account a constant growth rate of 5% with a discounting factor of 10%:
Use of the Constant Growth Rate:
The first part to this calculation is to determine the risk-free rate. For this scenario, we will assume a 10-year Treasury note is an accurate representation. The current yield on this particular bill as of May 5, 2015 is 1.965%. As it is not sold at par value, we can deduct actual selling costs (basically just administrative fees) to come up with 1.965% – 0.30 = 1.655%. This will be our risk-free rate (r).
The growth rate ratio between the discounting factor and the risk-free interest rate is calculated by putting these rates in the DCF formula. The formula for this part of the equation is:
(CF1+CF2+CF3+etc.+CFn)/(r-g), where DCF is the discounted cash flow, CFN is the last cash flow in time, r and g are the discounting rate and growth rate respectively.
Comparing this to our first example, we see that it says “compound annual growth rate” so we can take 10% as an annualized growth rate (AARR).
Similarly, we get 5% from 1.965% – 0.30 and multiply it by the constant growth (CAGR) of 5% in order to come up with 0.369%.
Our calculated risk-free rate is 1.965% – 0.369% = 1.321%. For this ratio, the appropriate discounting factor will be 10%, which gives us a calculated DCF value of $9,047,417.
The DCF valuation is a very useful tool for investors that are looking to understand the worth of a company in relation to its industry peers as well as its competitors and how they stack up against one another both on short term and long term perspectives. Using the DCF formula is a very mathematical approach to try and figure out, with an almost scientific background, all expected cash flows of the company and its discount rates. The DCF formula is useful because it takes into account how much risk will come into play when trying to predict the future expectations of a company and whether it will be able to deliver on those expectations. There are also many inputs that go into this formula that can keep it constant to be used as a “base” value in comparison to other companies within the industry.
This methodology is extremely useful in valuing companies so that they can decide how they want their performance measured. There are many different parameters that can be used within this valuation and they can all be made into their own set of assumptions.
There are always pros and cons to every investment, so there are many things to keep in mind when using the DCF model in order to avoid any issues. The first thing that every company needs to keep in mind is how accurate their assumptions are, which will directly affect how their DCF value is calculated. If you do not include accurate and reasonable numbers into your calculations, you can expect inaccurate results that might cause the investor to question all other portions of your DCF calculation, which will ultimately mess up the entire analysis leading to wrong decisions being made. The next thing to keep in mind is that you have to assume the growth rate will stay constant from year-to-year, which is a very difficult thing to do when using this formula because it is based on time. In most cases the growth rate will not be constant and it may increase or decrease depending on how well a company does. Another thing to keep in mind when using this method of valuation is that you have to take into account the quality of all assets being used as an investment. There are many things that can happen when dealing with financial assets; one of them being they can get stolen, destroyed or damaged. You need to take all of these things into account because they will affect how long a company will be able to deliver on their expected cash flows.
As a company looking to do a DCF valuation, there are many different areas for you to focus your attention on that will improve your overall results when using this method of valuation. The first thing you want to think about is going over your most recent financial statements and making sure that you are calculating your financial performance properly. There are many different pitfalls in the valuation process that can be caused by something as simple as not including proper financial statements in your calculations. For example, companies often times pay themselves using stock options instead of cash. These stock options will not be reflected in the accounting records, which will make a huge difference when trying to value a company using this method of valuation.
Another thing that can affect DCF valuations is changes in accounting standards. Sometimes these changes are very major and can completely change how companies do their financial reporting, which can mess up the entire DCF calculation and there is nothing you can do about it except try to make it as close as possible to your original numbers. Companies also tend to overvalue their assets and depreciate them too quickly, which can create a lot of problems when doing a DCF calculation. By the time you do your calculations, you may find that the company used an accounting method that suggests they have made a lot of money in a particular year, but in reality they performed poorly. This is why it is important to understand all of these different things going into your DCF calculation because if you do not your results will vary greatly from what the original valuation would suggest.
Uses of DCF
DCF can be used to value both equity and debt securities using inputs such as risk-free rate, growth rate etc. in a similar fashion to the formula.
Most firms use the DCF model to value assets, as it provides a useful way of comparing the values of assets across firms. This is done by calculating the cash flows over an appropriate period for a particular asset and then discounting them back to their market values. This is known as capital asset pricing model (PAPM). Capital Asset Pricing Model (CAPM) assumes that risk-free rate is proportional to the market risk premium earned by that asset, while CAPM also predicts that beta might vary across assets and time horizons due to risk-return tradeoffs in different securities. The risk-free rate is the discount rate that a security is expected to earn over its holding period, and the market risk premium is the return of an asset, over and above its expected risk-free rate. A beta of 1 means that an asset’s returns will move with the market.
The main utility of using DCF is that it allows for comparison between two companies by determining what their values are relative to one another at any point in time based on their respective growth rates and risk factors. The formula allows investors to compare systematically two companies which may have different accounting periods, different business models or operate in different markets.
DCF can also be used by private investors (such as individuals) when calculating their own investments which are funded with their own money rather than using a stock broker or bank account. This is particularly useful when investors are trying to determine the value of a company they own or intend to purchase.
DCF is used in scenario analysis, a technique used to determine the possible future risks and returns. DCF is also commonly employed in portfolio-construction methods such as the Kelly criterion and the capital asset pricing model (CAPM).
Investors can also use DCF to value their own companies using a combination of historical earnings, projected cash flows and growth rates. In addition, the model can be used to value a company’s share at a given point in time.
DCF is also used by financial analysts and valuation experts in order to determine the value of publicly traded companies using expected future cash flows that are discounted back at market interest rates.
Advantage
The main advantage of DCF is that it allows investors to make decisions based on data relative to companies they can measure and compare against one another. It also allows for a company to be valued relative to other companies. The accuracy of DCF is dependent on the number of assumptions that are made by the analyst, and it is possible to invalidate the model if there are flaws in the inputs.
Limitations of DCF
The DCF valuation methodology has its limitations. One key issue relates to estimating cash flows. Management forecasts about future cash flows are prone to bias. The use of management forecasts for forecasting purposes may lead to incorrect results because management forecasts tend not to be unbiased and independent; rather, they tend to be biased toward optimistic outcomes (the optimism bias). The use of the internal rate of return (IRR) instead of the discounted cash flow method may lead to incorrect results, however, a study by Fama and French found no evidence that the IRR was related to bad historical performance.
The main disadvantage of DCF is that it does not allow for an analysis comparing outcomes based on different sets of assumptions.
The DCF model is also susceptible to transaction costs because it assumes that the investor does not make any cash payments in the future. In reality , however, investors pay transaction costs when investing and borrowing money. These are considered opportunity cost and cannot be avoided by using DCF valuation.
