3.5.10. Discounted Cash Flow
Discounted cash flow (DCF) is a company’s projected cash flow, discounted to present value. A discounted cash flow (DCF) analysis is a valuation method based on the notion that the value of a company can be calculated from its projected free cash flow to the firm, discounted to its present value. It is widely utilized among industry professionals.
We will go over DCF analysis in much greater detail in the next chapter, as well as two other frequently used valuation methods, comparable companies analysis and precedent transactions analysis. This brief overview is just to expose you to the concept while the related metrics are fresh in your mind. It will also help get you ready for the next chapter by giving you a very general idea of what the process of producing a valuation looks like, regardless of method.
A DCF analysis looks somewhat like the NPV calculation above, specifically using FCFF as the measure for cash flow. First, you gather enough data to produce reasonable estimates of the company’s EBIT, capex, and the other components of FCFF. This gives you values for future FCFF that are grounded in justifiable assumptions. You then use the NPV formula to discount the next five years’ FCFF to its present value. A slightly different method will provide a “terminal value” representing the value of the company beyond the five-year period. The company’s WACC is used as the discount rate for both the five-year period and the terminal value.
The six discounted values (one for each of the next five years, plus the terminal value) are then added together, and the sum is treated as an estimated enterprise value for the company. This estimate is for the company’s current EV, not some future EV—after all, you discounted everything to its present value. In theory, the estimated EV is a reasonable price to pay now in order to receive the company’s projected future cash flow.
But why go to all that trouble for