Financial Valuation Concepts – Discounted Cash Flow

Financial Valuation Concepts - Discounted Cash Flow

When a financial analyst is required to conduct a financial valuation on the business or company being forecasted by the financial model, a commonly used valuation technique in a financial modeling exercise is the Discounted Cash Flow (DCF) method. 

The DCF method uses a nine step process to value a business enterprise:

  1. Forecast Free Cash Flow (FCF)
  2. Estimate the Weighted Average Cost of Capital (WACC)
  3. Use WACC to discount FCF
  4. Estimate terminal value (as known as residue value)
  5. Use WACC to discount terminal value
  6. Estimate total present value of FCF
  7. Add value of non-operating assets
  8. Subtract value of liabilities assumed
  9. Calculate value of common stock

The illustration below shows the 9 step approach to conducting a DCF valuation:

16_dcf.png

Question : Is a public listed company with market capitalization of $15,188 million value, or $39 per share, attractive?

Answer : A good financial modeler will always consider the context when answering this question. You would typically want to address this question from the stock market investor’s perspective and from the acquiror’s perspective.

Stock Market Investor’s Perspective

  • If the stock market prices the shares at $39, it is fairly valued.
  • If the stock market prices the shares at $30, you’ve found a bargain—buy the stock and hope that the market realizes the true value and bids-up its shares (this is unlikely, however, given efficient markets).
  • If the stock market prices the shares at $45, it is overvalued— beware of euphoria; seek more information about the story.

Acquiror’s Perspective

  • It depends on the price, or premium paid over $39 per share to gain control.
  • Acquisition premiums are generally about 40% so an acquirer of this business could expect to pay ~$55 per share or $12,419 million in total for full control.
  • Paying a significant premium over and above the market value of the company’s stock suggests that a buyer must be confident in realizing synergies far more than that in order to earn an adequate return on capital.

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3 Responses to “Financial Valuation Concepts – Discounted Cash Flow”

  1. […] Avoid short cuts – Use the nine-step DCF process! […]

  2. […] fundamental principles of valuation using the discounted cash flow valuation approach is talked […]

  3. […] the IRR is normally easier to understand than the result of a discounted cash flow (DCF) analysis (i.e. the net present value or NPV) for non-financial executives, it is often used to explain and […]

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