Download The Discounted Cash Flow (DCF) Model -- Chart School

The Discounted Cash Flow (DCF) Model -- Chart School
Chart School
The Discounted Cash Flow (DCF) Model
One of the most popular methods of valuation on Wall Street is the DCF, or Discounted Cash
Flow model. Because of its popularity, we will offer a basic explanation. See below for books
offering more details on financial models. The assumption behind the DCF model is that a
business is worth the present value of its future profits or cash flows. The whole point of starting
a business is to generate a profit or return. The whole point of an investment is to get a return
on our money. Stock is the investment and earnings are the returns on our investment. The
DCF model is a method of valuing a business today based on the stream of its future profits or
cash flows. The difference between the DCF valuation and the current stock price will determine
whether or not a stock is over- or undervalued.
Model Assumptions
The first step of a DCF valuation is building a financial model to estimate future revenues,
expenses, cash flow and earnings. Assumptions must be made to complete the financial model
and then assumptions must be made to deduce a final valuation. In order to forecast revenues,
expenses, taxes, interest and depreciation, assumptions must be made on future growth rates,
profit margins, market share and other items that affect the revenues and expenses. From
these assumptions it becomes possible to estimate future revenues, expenses, free cash flow
and earnings for future years, typically 5. Financial models rarely attempt to forecast more than
5 years. After the 5-year forecast period, an assumption of the continuing growth rate is used to
form a terminal value, which is sometimes called the continuing business value.
Multiplier Assupmtions
Once the financial model is built to forecast free cash flow and earnings, a second set of
assumptions is required to derive a valuation. (Note: Though definitions may vary, free cash
flow equals after-tax operating earnings plus non-cash charges, less investments in working
capital or other assets.) Fundamental analysts usually value companies as a multiple of their
free cash flow, earnings or even revenues. For example: if a company is valued at 10 times free
cash flow of 3$ per share, then the shares would be valued at $30. An assumption must be
made as to the level of the multiple over the next few years. If the multiple were 15, then the
same company would be valued at $45. The multiple is usually based on earnings visibility,
growth, business risk and comparisons within the industry. Airlines companies sell at low
multiples to reflect the cyclical business, slow growth, high debt levels, variable fuel costs and
high labor costs. Software companies sell at much higher multiples to reflect high growth rates,
high profit margins, flexible business models and low debt load.
For companies that do not earn any money, Wall Street uses different multipliers to arrive at fair
value. A multiplier should be based on a key revenue driver. For internet portals reliant on
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The Discounted Cash Flow (DCF) Model -- Chart School
advertising, the yardstick may be page impressions. For a cable company, it might be
subscribers. For an oil company, it might be reserves. If internet portals are being valued at 5¢
per page view and a company does 300 million page views per year, then fair value would be
estimated at $15 million (300,000,000 x .05 = 15,000,000). If an oil company has 30 million
barrels in proven reserves and oil is prices at $30, then that company might be valued at $9
billion. These are very simplistic valuations and many other factors (such as debt) are involved.
Examples of a DCF Model
Below is an example of a DCF model for a company (Wirelessnetworks.com). Don't go looking
for a wireless networking company with a .com on the end though, it is fictitious. Free Cash
Flow (FCF) was used to form the basis of the valuation. FCF was estimated to grow at 25% for
the next 5 years and for 15% after that into perpetuity. These are very respectable growth rates
that any company would be proud to claim, and even prouder to deliver. The weighted average
cost of capital (WACC) refers to how much it cost the company to fund its operations.
Companies raise money by either borrowing (debt) or issuing stock (equity). And yes, equity
does have a cost involved, but it is way too complicated to get into here. The present value of
money is based on the premise that a dollar tomorrow is worth than a dollar today. Based on
when they occur, future earnings are discounted based on the cost of capital and the number of
years in the future. The example below places the present value of $1.56 in earnings for the
second year at $1.34. Further below is a DCF model.
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The Discounted Cash Flow (DCF) Model -- Chart School
Key Assumptions
Weighted average cost of capital (WACC)
Current growth rate of free cash flow (or earnings)
Growth rate of FCF into perpetuity
Multiplier of final year FCF to compute the continuing value
8%
25%
15%
10%
All of these assumptions are the prerogative of the analyst. Based on this DCF model, the fair
value of the equity is about $30. If there were such a company today, it would probably be
selling for a lot more than $30.
For a bit of sensitivity analysis: If the 0-5 year FCF growth rate were jacked up to 50% and the
continuing growth rate to 25%, the estimated fair value of the company could be about $68.
However, these are very extreme growth rates that are unlikely to be sustainable for an
extended period of time.
At the end of the day, the DCF portion is probably the most important. If a company cannot
make a satisfactory return on investment, there is no reason to be in business. A DCF model
treats stock ownership as if an investor were buying the whole company. Return is the ultimate
determination of a good investment. Momentum is not considered to have an influence of the
profitability of a company.
Note: For more on valuation, see the following books:
●
Damodaran on Valuation - Aswath Damodaran
●
Measuring and Managing the Value of Companies - Copeland, Koller and Murrin 1996
Written by Arthur Hill
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The Discounted Cash Flow (DCF) Model -- Chart School
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