DCF Valuation Summary

Understanding DCF Valuation

Discounted Cash Flow (DCF) analysis is a valuation method used to estimate the value of an investment based on its expected future cash flows. It attempts to determine the present value of an investment today by projecting future free cash flows and discounting them back to the present using a required rate of return.

DCF Formula:

DCF = Σ_t=1ⁿ [FCF_t / (1 + r)^t] + TV / (1 + r)ⁿ

Where:

• FCF_t = Free Cash Flow in period t
• r = Discount Rate
• n = Number of projection years
• TV = Terminal Value

Calculating Free Cash Flow (FCF):

The Free Cash Flow is calculated using the following formula:

FCF = NOPAT - CapEx - ΔWorking Capital

Where:

• NOPAT = Net Operating Profit After Taxes = EBIT × (1 - Tax Rate)
• CapEx = Capital Expenditures (% of Revenue)
• ΔWorking Capital = Change in Working Capital (% of Revenue)

Calculating Terminal Value (TV):

The Terminal Value estimates the value of the investment beyond the projection period, calculated using the Gordon Growth Model:

TV = [FCF_n × (1 + g)] / (r - g)

Where:

• FCF_n = Free Cash Flow in the final projection year
• g = Terminal Growth Rate

Why DCF Matters:

• Provides an estimate of intrinsic value based on expected future performance
• Accounts for the time value of money by discounting future cash flows
• Useful for comparing different investment opportunities on a consistent basis
• Widely used in finance for valuing companies, projects, and assets

Limitations of DCF:

• Highly sensitive to inputs, especially growth rates and discount rate
• Requires accurate forecasting of future cash flows, which can be challenging
• May not account for qualitative factors that affect a company's value
• Terminal value often constitutes a large portion of the total valuation, increasing uncertainty

While DCF is a powerful valuation tool, it's important to use it alongside other valuation methods and consider qualitative factors for a comprehensive analysis.