Chapter 2 - The discounted cash flow method1

2.1 What is the DCF Method?

The Discounted Cash Flow (DCF) Method is a theoretical estimation of the present value of a project, business or companys assets. The method calculates the intrinsic value of projected cash flows adjusted for the time value of money and the cash-flow risk (risk premium). The output is the present value of the stream of cash flows. The value that results from the DCF calculations depends on the cash flows being discounted. Free Cash Flow to the Firm (FCFF) is defined as the cash flow generated by a project or a companys operations before any debt service or interest paymentsare taken into account. If the cash flows taken into account for DCF purposes are the FCFF, the resulting value is equal to the enterprise value (EV). If Free Cash Flows to the Equity (FCFE, defined as residual cash flows to equity holders after deducting the amounts needed to service the debt and pay interest) are taken into account, the resulting valuation corresponds to a measure of the equity value, which can be compared to the market value for quoted companies. The DCF method rests on certain assumptions for projections of company revenues, costs and projected investments as well as financial assumptions, including the Weighted Average Cost of Capital (WACC). While the method is extremely sensitive to these assumptions, practitioners agree that it remains a leading method of company valuation. The right approach consists of acknowledging the methods limitations, including its sensitivity to certain assumptions (namely, the weighted average cost of capital), and ensuring that these assumptions mirror reality as close as possible. For new projects with limited history, analyst experience is of great importance. In contrast, for existing companies with a track record, use of historical figures that correspond to the companys actual track record across the business cycle constitutes best practice. Honest assumptions and historical figures guarantee valuation integrity. The fact that a small change in the assumptions

2012, Hugo Mendes Domingos and Eduardo Vera-Cruz Pinto

leads to a significant change in valuation only causes concern when those responsible for the valuation cannot back up their assumptions or build credibility into the numbers. The difficulty in the assumptions of DCF is not related to the method itself but rather to the actual assumptions being used. Those using the DCF method for investment analysis, decision-making or as a backup tool for negotiation should focus on carefully supportingtheir work and understanding the valuations sensitivity to key assumptions. Once these critical aspects are covered, the analyst will find that the valuation discussion is enhanced within the team and with third parties. Equation 1below illustrates the formula used for calculations with the DCF method. Equation 1. DCF Formula

2.2

When should the DCF Method be used?

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