Imagine you invest in your friend’s business. You sign a contract that says you are entitled to all the cash after he pays for all aspects of the business (e.g. materials, selling costs, salaries, taxes, etc.). What would this business be worth to you? You definitely wouldn’t want to invest more than what you’ll get in the future. Discounted cash flow analysis (DCF) is here to help you – it is a tool to calculate how much you’ll get in the future, and how much is fair to pay for it today.
Therefore, DCF is considered to be the essential valuation method because it is trying to determine intrinsic value of the company. The analysis assumes that the company is worth as much as its present value of all unlevered free cash flows, discounted at the company’s weighted average cost of capital (WACC). In other words, analysis says that a company is worth all of the cash that it could make available to investors in the future. And it is discounted because the money in the future is worth less than money today.
The main analysis’ weakness is that it is based on many assumptions (about available cash flows, time frame, cost of capital, growth rate, etc.), and even a small change in them can result in vastly different company values.
Steps to DCF are following:
1. Calculate Free Cash Flow using forecasted financial statements
2. Discount Free Cash Flows using the Weighted Average Cost of Capital (WACC) – the blended cost of capital for debt and equity
3. Determine Terminal Value (value of the company at the end of the forecasting period)
There are two ways to determine terminal value – perpetuity growth method and terminal multiple method.
Perpetuity growth method
The goal is to calculate the value of company’s cash flows assuming that they will grow forever at some modest rate (e.g. 3%)
Terminal multiple method
This method assumes that the terminal value of the company equals to its EBIT or EBITDA multiplied by the multiple. The multiple is usually obtained through the comparable analysis.
Once you obtained the terminal value, you again have to discount it to the present.
4. Add the present values of all forecasted Free Cash Flows and Terminal Value together.
This shows you the total enterprise value of the company TODAY.
5. Subtract value of net debt (debt – cash) and any preferred stock to calculate equity value.
6. Divide the derived equity value by the number of shares outstanding to get the share price.
7. Compare the price you got to the actual price in the market and determine if the company is being traded at a premium/discount.