Discounted cash flow valuation

In the dynamic world of finance, valuation stands as a critical process, offering insights into the intrinsic worth of an investment or business. Value of an asset is important to determine its monetary worth. Value of an asset might be different for different people. For Example, if we have a piece of land, it may have a different value for a farmer who would grow crops on it and for a real estate Company which would want to develop and then resell it and for a Manufacturing Company who wants to set up a plant on that land.

There are multiple ways in which an asset or business can be valued – Asset Based Valuation (e.g. Book Value Method), Markets Based Valuation (e.g Multiples method), Cash flow based valuation. Among the various valuation methodologies, Discounted Cash Flow valuation (DCF Valuation) holds a prominent position, providing a comprehensive analysis of a company’s financial health and future prospects.

In this article, we will delve into the fundamentals of valuation, explore the intricacies of DCF valuation, understand its methodology, and evaluate the drivers of cash flows. Additionally, we will discuss the advantages and limitations associated with employing DCF in the valuation process.

Table of Contents

Understanding Valuation

Valuation is the process of determining the present value of an asset, investment, or company. It involves assessing the financial metrics, market conditions, and growth prospects to arrive at a fair and objective estimate of the entity’s worth. Valuation serves as a fundamental tool for investors, analysts, and consultants alike, aiding in informed decision-making regarding investments, mergers, acquisitions, and strategic planning.

What is Discounted Cash Flow Valuation?

Discounted Cash Flow valuation (DCF Valuation) is a widely accepted method for assessing the intrinsic value of an investment or business. This method is also known as intrinsic value method. At its core, DCF revolves around the time value of money, recognizing that a dollar today is worth more than a dollar in the future. The methodology involves forecasting future cash flows, discounting them back to their present value, and deriving the net present value (NPV) as a measure of the investment’s attractiveness. Present value of cash flows till perpetuity (over long term) is the intrinsic value of the Company.

How is DCF Valuation Done?

DCF valuation typically involves the following:

Forecasting the future cash flows of the business. The time frame for the forecast depends on the Company and stability of the cash flows. For a Company with stable cash flows, 3-5 year projection typically holds good. For a start up or immature business cash flow projection may be required for a longer period till the business is able to generate stable and consistent cash flows.
Determination of discount rate. The discount rate, also referred to as the weighted average cost of capital (WACC), is a crucial component in DCF valuation. It reflects the opportunity cost of capital and accounts for the risk associated with the cash flows/ investment. WACC considers the cost of debt, equity, and preferred stock, weighted by their respective proportions in the capital structure.
Terminal Value of business. Terminal value of the business is the value of business beyond the explicit forecast period. It becomes challenging to make accurate cash flow predictions beyond the forecasting period (say 5-10 years). Therefore, a terminal value is calculated to capture the value of the business beyond the forecast period. The terminal value is usually determined using one of two methods: the perpetuity growth model (also known as the Gordon Growth Model) or the exit multiple method.
Calculation of Discounted cash flows. Future cash flows are discounted back to their present value using the determined discount rate (or WACC). This step acknowledges the principle of time value of money and reflects the diminishing value of money over time. Cost of Equity and Capital for US companies (for reference purposes).

Calculation of Net Present Value (NPV).The summation of discounted cash flows results in the Net Present Value (NPV). A positive NPV implies that the investment is expected to generate returns higher than the required rate of return, indicating a potentially lucrative opportunity. In context of a Company valuation, intrinsic value or Enterprise value of business is the present value of future cash flows.

Drivers of Cash Flows:

Understanding the drivers of cash flows is essential for accurate DCF valuation. Key drivers include:

Revenue Growth – The rate at which a company’s revenue is expected to grow significantly impacts cash flows. Sustainable and consistent revenue growth is indicative of a healthy business.
Operating margins – Efficient cost management and high operating margins contribute positively to cash flow generation. Operating margins reflect the profitability of core business operations.
Capital Expenditures – Capital expenditure is required for the maintenance and growth of the business. Prudent management of capital expenditures enhances cash flow efficiency.
Working Capital Management – Effective management of working capital, including inventory, receivables, and payables, affects the operating cash flow. Efficient working capital practices can improve liquidity and overall financial health.

Advantages of DCF Valuation:

Incorporates Future Cash Flows – DCF valuation considers the future cash flows, providing a forward-looking perspective that goes beyond historical performance.
Customizable and Flexible – Analysts can tailor DCF models to fit specific business scenarios and industries, making it adaptable to various valuation needs.
Sensitivity Analysis – DCF allows for sensitivity analysis, enabling analysts to assess the impact of changes in assumptions on the valuation, enhancing the robustness of the results.

Limitations of DCF Valuation:

Assumptions based – DCF valuation heavily relies on assumptions about future cash flows, discount rates, and terminal values. Small changes in these assumptions can significantly impact the results.
Complexity and Expertise – Performing a DCF analysis requires a deep understanding of financial modelling and valuation techniques, making it complex and necessitating expertise.
Cash flow prediction for non mature Companies/ industries: DCF may face challenges in valuing companies with unpredictable cash flows, especially in industries characterized by short-term volatility and rapid changes.

Conclusion:

Discounted Cash Flow (DCF) valuation stands as a powerful tool for unlocking the intrinsic value of an investment or business. By considering future cash flows and incorporating the time value of money, DCF provides a comprehensive and forward-looking assessment. While it comes with its advantages, such as flexibility and sensitivity analysis, DCF valuation demands a careful approach due to its reliance on assumptions and the expertise required for accurate implementation. As a consultant, integrating DCF into your toolkit can enhance your ability to offer insightful and informed advice, ensuring your clients make strategic decisions aligned with their financial objectives.