Step One: Estimating Future Cash Flows
Since a DCF is in essence a prediction of a company’s future value, it is important to understand that company’s traits, development trends, and direction. By gaining an overall understanding of the target company’s business and financial profiles, historical performance, and estimated future outlook, an investment banker can begin to develop an accurate metric for valuation. Researching the company’s recent earnings and profitability is a good place to start. Looking at the last three-year values for these and other key metrics and combining that information to trends and expected growth rates in that company’s industry will help you to develop a better understanding of the strength of the target company. This type of research will also allow you to more reasonably predict the company’s future performance.
Once you have learned about the target, it is time to estimate the company’s future cash flows. This process is obviously critical, and it is subject to many potential pitfalls. Free cash flow to the firm is typically made for a finite period of time, most commonly five years. Though it is not sufficient to simply extrapolate past results or to assume a constant increase in value, it is common for past growth rates, profit margins, and other valuation ratios and metrics to serve as reliable indicators of future performance. Typically, a review of the important figures from the target company’s statements of income over the last three fiscal years provides the most essential data. Generally speaking, utilizing the target’s revenue, COGS, SG&A, EBIT, and EBITDA from recent years will help you to formulate a basic expectation for growth performance in the first two to three years of the five-year projection period.
Other factors, however, are of equal and at times greater importance to determining future cash flows. Among these are:
- • Specific information from target company mana