The Discounted Cash Flow is the mother of all valuation techniques. If done correctly, it can provide a very good valuation of a company. However, there are some significant drawbacks which have lead to the DCF being less used on Wall Street than other valuation methods.
The Discounted Cash Flow Model is exactly what it sounds like – it is a present value of all of the cash flows a shareholder can expect. This is done by (1) determining the future cash flows and (2) determining the Weighted Average Cost of Capital. Neither of these are simple tasks.
Determining the future cash flows of a business require, as expected, a forecasted cash flow statement. While this can be forecast by itself, it may be more appropriate to build and forecast a full three statement model. Whichever way you choose to do it, the goal is then to determine the free cash flows of the business.
This is relatively simple, as it just involves the allocation of cash to things like working capital, and everything that is left is what is available to shareholders.
Usually, however, it can be difficult to forecast the cash flows year by year, and the DCF requires you to do it to infinity. There, most DCF models will involve several stages. For simplicity, we will consider a two stage model. The first stage involves forecasting the next five to seven years of the business’ cash flows. This is done with care, as in this range the cash flows are significant when discounted back. Beyond that, we use an assumption as to how the business will continue to operate, in order to get the rest of the cash flows.
There are two ways we can make this assumption. Either, we can assume that the cash flows will grow at a certain growth rate, and use the perpetuity formula to find a present value. Alternatively, we can use some EBITDA multiple assumption to determine an enterprise value.
Next is determining the ‘Weighted Average Cost of Capital’. This is an extremely controversial subject and textbooks have literally been written on different ways to determine what the WACC is. Simply put, though, it takes into account the capital structure of the firm, and prices the debt and equity. The weighted average of the debt and equity prices is the WACC.
Once both of these things are determined, all cash flows can be discounted back to the present, giving us an equity value today. This equity value is divided up among the outstanding shares and we derive a share price.
Often, DCF models will provide sensitivity analysis based on the different assumptions in the model, as they can have massive effects on the derived stock price.
While academically rigorous, the amount of work that goes into a DCF doesn’t give a result that is useful in many situations, and so is used much less often than other valuation techniques in Investment Banking.