7 Steps to Calculating a DCF Valuation

Introduction

Discounted Cash Flow (DCF) Valuation is a method of valuing a company based on projections of its expected future cash flows. By discounting these cash flows to their present value, investors can assess whether an investment is worthwhile.

DCF Valuations are important to investors because they provide an analytical grasp of an investment opportunity. They can be used to assess whether the potential reward from investing in a company is sufficient relative to the risk of loss. For example, it can be used to compare two potential investments and determine which is a better choice.

In this blog post, we'll outline the 7 steps necessary for calculating a DCF Valuation.

Prepare Financial Projections

In the second step of a Discounted Cash Flow (DCF) Valuation, one needs to prepare financial projections representing future cash flows for the company. This can involve significant research and number-crunching, but it is extremely important to ensure accurate projections.

Input assumptions necessary for projections

The first step in preparing financial projections is to build the necessary assumptions. This requires both external market research by collecting data from industry and competitive analysis, as well as internal investigation into a company’s sales and operating costs. All this data allows the analyst to have an understanding of the business and the industry and allows them to build appropriate assumptions for their financial projections.

Develop Robust Forecasting

Once the assumptions have been built and laid out, the financial projections themselves can be developed. Depending on the granularity required by the analyst, models can range from simple to complex. For most DCF Valuation frameworks, however, the analyst should ideally aim to consider many factors, such as balance sheet requirements, market size, and sales growth. By taking into account these various components, the analyst can build a robust forecasting model.

• Gather industry and competitive intelligence
• Receive business inputs from stakeholders
• Adjust assumptions to match reality
• Calculate financial forecasts from sales, costs, and investments
• Run simulations for different growth scenarios
• Perform sensitivity analysis to fluctuations in growth
• Test for assumptions’ accuracy by running through scenarios

Estimate Free Cash Flows

Calculating a DCF (Discounted Cash Flow) valuation can be a complicated process. To begin the process of this type of valuation, it's important to accurately estimate the free cash flows that can be expected from the subject of the analysis.

Project Future Cash Flows

The first step in the DCF valuation process is to project the future cash flows of the company or asset being evaluated. This means creating a forecast of the cash inflows and outflows associated with the business or asset. While it can be challenging to project future cash flows, there are several techniques that can be employed to create an accurate projection that can be used for the DCF calculation.

Develop Risk Assessment Process

In addition to accurate cash-flow projections, it's important to consider the risk associated with the forecast. Depending on the type of investment being made and the level of uncertainty associated with it, the risk assessment process can include methods such as sensitivity analysis, scenario analysis, and Monte Carlo simulation. By assessing the various risks associated with the DCF analysis and taking steps to minimize them, investors can make more informed decisions.

Creating an accurate DCF valuation requires estimating future cash flows and assessing associated risks. By taking the time to accurately project cash-flow and developing a risk assessment process to minimize uncertainty, investors can make informed decisions when evaluating potential investments.

Estimate Terminal Value

In order to accurately calculate a Discounted Cash Flow (DCF) valuation, the terminal value needs to be estimated. This will help you to determine the present value of the estimated cash flows in the terminal period.

Select Appropriate Method

The inflation-adjusted Gordon Growth Model is commonly used to estimate the terminal value. The model assumes a constant growth rate of the cash flows after the terminal period and is used to calculate the value of the company in perpetuity.

Estimate Future Cash Flows

In estimating the future cash flows, you will need to consider several factors, including but not limited to the following:

• Growth rate of existing markets
• Entry into new markets
• Cost efficiency and profitability
• Availability of new technologies or processes

You should also consider factors that could affect the growth of revenues and cash flows, such as inflation, industry fluctuations or market saturation.

5. Calculating Discount Rate

The next step in computing a DCF valuation is to calculate the discount rate. The discount rate is used to convert future cash flows into present values. It reflects the rate of return that a company must generate to provide a given level of return to investors. The discount rate can be a company’s cost of capital, a variable specific to the asset or business, or a market-determined rate.

a. Determine Required Rate of Return

The first step in determining a discount rate is to determine the required rate of return. This rate should reflect the level of return that is required by investors given the risks of the investment. The required rate of return should be higher than equivalent risk-free investments, such as government bonds, as investors will require additional return to compensate for the risks associated with the investment.

b. Calculate Weighted Average Cost of Capital

Next, the weighted average cost of capital (WACC) can be calculated. The WACC is the after-tax cost of funding a company’s operations and capital investments. It takes into account the debts and equity that the company has, as well as the tax benefits associated with them. To calculate the WACC, the cost of debt and cost of equity should be determined, then weighted according to the percentage of debt and equity that the company has.

• Cost of Debt: This is the cost of interest on any debt that the company has.
• Cost of Equity: This is the return that shareholders demand from the equity of the company.

Calculating Value of Equity

The sixth step in a Discounted Cash Flow (DCF) Valuation is calculating the value of equity. To do this, the sum of discounted cash flows must be added together and the Enterprise Value must be estimated.

Adding Up Discounted Cash Flows

Using the calculated free cash flows in each period, the total cash flow discounted at the weighted average cost of capital (WACC) determines the Total Discounted Cash Flows (TDFC). This value indicates the sum of cash flows that the business must receive to equal or exceed the value of the investment.

Estimate Enterprise Value

From the TDFC the Enterprise Value (EV) can be calculated. The EV is the sum of the cost of equity and debt taken to generate the discounted cash flows. This is done by subtracting the net debt from the TDFC.

For example, if the total discounted cash flows are calculated to be 320 million and 250 million is net debt, the enterprise value of the business is 70 million.

To calculate the Value of Equity the EV must be subtracted by the net debt. In this example, the value of equity would be 70 million minus the 250 million which is -180 million.

Conclusion

DCF valuation is a useful tool for investors as it provides a holistic view of a company's performance and potential. It allows investors to consider both historical and predicted financials to arrive at the company's true worth. Understanding this process and correctly applying the necessary calculations and assumptions is key to arriving at an accurate DCF valuation.

Having taken a look at the seven steps to calculating DCF valuation, it is important to remember that the accuracy of a DCF valuation depends on its assumptions. Mitigating this risk comes from a thoughtful and realistic approach to creating these assumptions based on a company's context.

Summarize importance of DCF Valuation

DCF is an important tool for investors as it can help them make more informed decisions and provide a predictive measure of a company's worth. By taking the time to analyze both a company's predictions for future performance, as well as its historical performance, a DCF valuation can provide investors with a full perspective on the company's true value.

Analyze the accuracy of the results.

The accuracy of a DCF valuation can be affected by its assumptions, which can range from the discount rate to the revenue growth rate. Using assumptions that are not accurate to a company's specific context can lead to an inaccurate result. Thus, it is important to consider a company's specifics when creating these assumptions to ensure the accuracy of the valuation.