Basic Valuation Model (Discounted Cash Flow Valuation Method)
A valuation method employed to approximate the attraction of an investment opportunity. Discounted cash flow (DCF) analysis uses succeeding free cash flow projections and discounts them which is most often using the weighted average cost of capital to make it at a present value, which is employed to evaluate the potential for investment. If the value made it at through Discounted cash flow analysis is greater than the current cost of the investment, the opportunity may be a good one.
The discounted cash flow (DCF) analysis shows the net present value (NPV) of projected cash flows available to all suppliers of capital, net of the cash requisite to be invested for bringing forth the proposed growth. The concept of discounted cash flow valuation is based on the principle that the value of a business or asset is inherently depend on its capital to bring forth cash flows for the suppliers of capital. To that extent, the discounted cash flow relies more on the fundamental expectations of the business than on public market factors or historical precedents, and it is a more theoretical approach trusting on numerous presumptions. A discounted cash flow analysis concedes the overall value of a business i.e. enterprise value, letting in both debt and equity.
Key elements of a DCF
- Free cash flow (FCF):
It is the cash generated by the assets of the business i.e tangible and intangible available for distribution to all suppliers of capital. Free cash flow is often referred to as unlevered free cash flow, as it represents cash flow available to all suppliers of capital and is not dissembled by the capital structure of the business.
- Terminal value :
It is a value at the end of the Free cash flow projection period in horizon period.
- Discount rate:
It is the rate employed to discount projected Free cash flow's and terminal value to their present values.
Projection of Inputs: Discount Rates
- Critical component in discounted cash flow valuation. Errors in figuring the discount rate or mismatching cash flows and discount rates can lead to serious faults in valuation.
- At an non rational level, the discount rate employed should be reproducible with both the riskiness and the type of cash flow being discounted.
i) Equity v/z Firm:
If the discounted cash flows are similar to cash flows to equity, then the appropriate discount rate is a cost of equity. If the cash flows are similar to the cash flows to a firm, then the appropriate discount rate is the cost of capital.
ii) Currency :
The currency in which the cash flows are estimated should to a very great extent be the currency in which the discount rate is estimated.
iii) Real v/s Nominal:
If the cash flows stated as discounted are nominal cash flows (i.e., reflect countered inflation), the discount rate should be nominal.
Cost of Equity
Ø The cost of equity is the rate of return that investors are requisite to make an equity investment in a business firm. There are two ways to estimating the cost of equity:
a) A dividend-growth model.
b) A risk and return model
Ø The dividend growth model that outlines the cost of equity to be the sum of the countered growth in earnings and the dividend yield is based upon the assumption that the current price is equal to the value. It cannot be employed in valuation, if the objective is to find out if an asset is correctly valued.
Ø A risk and return model, on the other hand, attempts to answer two questions:
i) How to measure risk?
ii) How to translate this risk measure into a risk premium?
Discounted cash flow models are strong, but they do have defects. Discounted cash flow is merely a mechanically skillful rating tool, which makes it subject to the maxim garbage in, garbage out. Small alterations in inputs can outcome in large alterations in the value of a company. Instead of attempting to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is employed to estimate the terminal value past 20 years, for instance . This is done since it is tough to come to a realistic estimate of the cash flows as time goes on.
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