Discounted Cash Flow valuation method

Discounted Cash Flow valuation method

Despite these points about cash flows, the most popular contemporary approach to valuation emphasizes cash flows pure and simple. Called discounted cash flow (DCF) analysis, the method also presents a number of choices an analyst must make.

EBIT and EBITDA: Cash flows can be measured in alternative ways. Chief examples are operating income (earnings before interest and taxes, called EBIT) and operating income plus the noncash expenses of depreciation and amortization (called EBITDA). Devotees of discounted cash flow valuation analysis rarely use accounting-driven metrics such as operating income.

DCF valuation for a medium-term period, typically 5 to 10 years.

Once cash flows are defined using one of these metrics, the discounted cash flow valuation method estimates them for a medium-term period, typically 5 to 10 years.

The estimate entails examining a range of performance variables that drive cash flows, chiefly sales levels, profit margins, and required reinvestment in the business through capital expenditures (cap-ex).

With cash flows projected, the method discounts each year’s estimate by a discount rate intended to reflect the subject company’s cost of capital during the period.

Each year’s discounted result is added to all others to produce a preliminary valuation of the 5- or 10- year period.

DCF valuation for period beyond the medium term, to yield the perpetuity amount.

For cash flows beyond the medium term, an additional step estimates the further cash expected in perpetuity, at a constant growing rate. This is typically done by estimating the final year’s cash flows and multiplying it by some figure to yield the perpetuity amount.

The figure is determined by the relationship between the assumed growth rate and the relevant cost of capital at that horizon period.

It is equal to 1 divided by the difference between these rates – so with a cost of capital of 10 percent and a growth rate of 5 percent, the multiplier is 20 determined by 1/ (10 percent – 5 percent).

Overview

The requisite math is elegant, easy, superficially scientific and seemingly objective. The raw data is estimated, just as easily, but substantially artistic and actually subjective. Underscore the heroics:

• cash flows estimated for 5 or 10 years,
• cash flows in perpetuity,
• discount rates going out 10 years plus, and
• a growth rate on top of that in perpetuity.

Also read:

1. Cash Flow Statement Value
2. Discounted Cash Flow valuation method
3. Hazards of the Future and Limitations of DCF