Discounted Cash Flow (DCF) Analysis Step-by-Step Walkthrough
Discounted cash flow (DCF) analysis refers to the gold standard methodology for asset valuation. In its simplest terms, DCF estimates the present value of an investment based on its expected future cash flows.
Estimations generally range from 3-5 years (cash flows up to five years from present day) but can be done further out if the investment is expected to be held for many more years.
The assumption underlying this valuation method is the value of any asset (company) is equal to the value of all its future earnings discounted to present day.
Money now is better than money later, meaning $100 today is worth more than $100 five years from now. The reason for this is one could, presumably, earn a return on a smaller investment, say $80, over that five year period that would turn into $100.
In other words, $100 five years from now could easily be worth $80 today depending on the expected return you’d be giving up during that time.
Similarly, investors projecting a company’s earning five years from now to be $500M may only be willing to pay $400M based on their DFC analysis.
This difference between the nominal value of future earnings and their present value is what’s know as the discount rate (the D part of DCF).
DCF valuations, then, simply attempt to estimate future cash flows, discount them according to the appropriate rate, and add all of them up to arrive at a reasonable valuation.
The trickiest part of DCF analysis, in terms of accuracy, is going to be the projected cash flows because they rely on a lot of assumptions, but as long as you maintain a thoughtful and conservative approach, it should lead you to a reasonable valuation.
Before I get into the step-by-step walkthrough, let me briefly break down each piece of the DCF formula:
Discounted Cash Flow (DCF) Formula:
CF = the cash flow for each projected year. If you’re projecting cash flows five years into the future, you’ll eventually have five different CFs to add together towards the end of your valuation. Part of the CF you’ll be adding to your projected cash flows for each year is the terminal value, which refers to the value of cash flows beyond the forecasted period, but I’ll explain that in more detail in PART III.
r = the discount rate in decimal form. This is essentially the required (minimum) rate of return you expect from the investment. Most investors use a company’s weighted average cost of capital (WACC).
n = the year corresponding to the relevant projected cash flow. If you are projecting cash flows five years into the future, you’ll need to discount each year by a larger factor. Year 1’s discount rate would be raised to the power of 1, year 2’s discount rate would be raised to the power of 2, and so on.
DCF = the sum of all the projected free cash flows (including the terminal value) after being discounted.
With that out of they way, buckle up and let’s get started.
Disclaimer:
*Throughout this step-by-step walkthrough, there will be references to averages pulled from existing data to extrapolate future data.
If you want to calculate a conservative valuation, you can replace those averages with the lowest value from each of the years you measure.
If you want to calculate a valuation more optimistic toward growth, you can replace those averages with the highest value from each of the years you measure.
Keep in mind, however, there are many factors that can contribute to different rates of growth in the future and past growth is not indicative of future growth.
You are free to use any number you want in lieu of the averages based on your own analysis, but averages are the simplest and thus they will be used as a placeholder throughout this step-by-step walkthrough.*
PART I - PROJECTED FREE CASH FLOWS (CF)
STEP 1 (Free Cash Flow):
Calculate the free cash flow (FCF) or the free cash flow to equity (FCFE) (%) for the previous 3-5 years. The latter (FCFE) can be difficult to project because of net borrowings, so use FCF for a simpler option (or if net borrowings are very low).
FCF = Operating Cash Flow - Capital ExpendituresFCFE = Operating Cash Flow - Capital Expenditures + Net Borrowings
STEP 2 (Free Cash Flow Growth Rate):
Calculate the free cash flow growth rate (%) for each of the previous 3-5 years by dividing the free cash flow by net income.
FCF(E) Growth Rate (%) = FCF(E) ÷ Net Income
Calculate the average of these rates and save it for Step 7.
STEP 3 (Free Cash Flow Growth Rate):
Find the revenue growth rate (%) for the previous 3-5 Years.
Revenue Growth Rate (%) = (Total Revenue ÷ Previous Year’s Total Revenue) - 1
Calculate the average of these rates and use it in the following step.
STEP 4 (Projected Total Revenue):
Take the average revenue growth rate (%) and use it to project the following 3-5 years of total revenue ($).
Use the most recent total revenue to protect the first year, use that projected year to project the second year, and so on.
Projected Total Revenue = Most Recent Total Revenue x (1 + Average Revenue Growth Rate)
STEP 5 (Net Income Margins):
Once you have the total revenue projections, determine the net income margins (%):
Net Income Margins = Net Income ÷ Total Revenue
Calculate the average of these margins and use it in the following step.
STEP 6 (Projected Net Income):
Take the average net income margin (%) and multiply it by the projected total revenues ($) for each year to get the projected net income ($) for each year.
Projected Net Income = Projected Total Revenue x Average Net Income Margin
STEP 7 (Projected Free Cash Flows):
Take the free cash flow rate (%) calculated in Step 2 and multiply it by the projected net incomes for each year to get projected free cash flows for each year.
Projected FCF = Projected Net Income x Average FCF(E) Rate
You now have the CF (minus the terminal value) in the DCF equation.
PART II - THE DISCOUNT RATE (r )
Now it’s time to discount the projected free cash flows for each year according to the appropriate discount rate.
Investors typically use the weighted average cost of capital (WACC) for their discount rate, but you can also use your desired annualized rate of return (the minimum return you expect or demand form the investment).
The WACC for any company is the minimum return it needs to generate to create value (stay in business). Put another way, WACC is the minimum return investors are demanding from that company based on the investment’s perceived level of risk.
This essentially makes WACC the return investors would be missing in similar investments each year they’re invested, which is why the projected cash flows are discounted by that return (the opportunity cost).
WACC is calculated by (1) multiplying the cost of each capital source (equity and debt) by its relevant market value weight, (2) multiplying the weighted cost of debt by the company’s effective tax rate, and (3) adding that number to the weighted cost of equity.
Weighted Average Cost of Capital (WACC) Formula:
WACC = (Market Value of Equity (MVE) ÷ (MVE + MVD) x Cost of Equity ) + (Market Value of Debt (MVD) ÷ (MVE + MVD) x Cost of Debt x (1 - Effective Tax Rate)
STEP 1 (Market Value of Equity):
Calculate the market value of equity (MVE) ($). For simplicity’s sake, the company’s market capitalization can be used as the MVE.
STEP 2 (Market Value of Debt):
Calculate the market value of debt (MVD) ($) by adding all current debt and long- term debt (found on the Balance Sheet). Oftentimes, platforms/companies will in- clude total debt for you.
MVD = Total Debt (Current Debt + Long-Term Debt)
STEP 3 (MVE + MVD):
Add the MVE (E) ($) and MVD (D) ($) together to get V (the total value of the company’s capital structure) ($). In other words, market capitalization plus the total amount of debt.
V = E (Market Capitalization) + D (Total Debt)
STEP 4 (Weight of Equity):
Calculate the weight of equity (%) by dividing MVE (market capitalization) by V.
Weight of Equity (%) = MVE ÷ V
STEP 5 (Weight of Debt):
Calculate the weight of debt (%) by dividing MVD (total debt) by V.
If you already have the weight of equity, you can just subtract that percentage from 100 to get the weight of debt.
Weight of Debt = MVD ÷ V
STEP 6 (Cost of Equity):
Calculate the cost of equity (%) by multiplying the stock’s beta (found under the Yahoo Finance Statistics tab) by the difference between the market rate of return and the risk-free rate (Market return minus the 10-year Treasury).
The market return input can be the average return of the overall market (measured by the S&P500 or other major index) for the last 10 - 20 years. 10% is usually a good average, but a quick google search can give you a more accurate number.
Once you have the difference between the market return and the risk-free rate and multiply that by the stock’s beta, add the risk-free rate to get the cost of equity (%).
Cost of Equity (%) = Risk-Free Rate + Beta x (Average Market Return - Risk-Free Rate)
STEP 7 (Non-Tax-Deducted Cost of Debt):
Calculate the non-tax-deducted cost of debt (%) by dividing the total interest expense ($) (found on the Balance Sheet) by the total debt ($).
Non-Tax-Deducted Cost of Debt (%) = Total Interest Expense ÷ Total Debt
STEP 8 (Effective Tax Rate):
Calculate the effective tax rate (%) by dividing the income tax expense ($) (often called the “Tax Provision” on the Income Statement) by the income before tax ($) (pretax income).
Companies frequently list their effective tax rate for you in the “Provision for Income Taxes” section of their annual reports (10K).
Effective Tax Rate (%) = Income Tax Expense ÷ Income Before Tax
STEP 9 (Cost of Debt):
Subtract the effective tax rate (%) from one and multiply it by the non-tax-deducted cost of debt to get the actual cost of debt.
Companies can write off interest paid on debt, so this calculation will account for that money saved.
Cost of Debt (%) = Non Tax-Deducted Cost of Debt x (1 - Effective Tax Rate)
STEP 10 (Weighted Cost of Equity):
Take the weight of equity (%) from Step 4 and multiply it by the cost of equity (%) from Step 6 to get the weighted cost of equity (%).
Weighted Cost of Equity (%) = (MVE ÷ V ) x Cost of Equity (%)
STEP 11 (Weighted Cost of Debt):
Take the weight of debt (%) from Step 5 and multiply it by the cost of debt from Step 9 to get the weighted cost of debt (%).
Weighted Cost of Debt (%) = (MVD ÷ V ) x Cost of Debt (%)
STEP 12 (Solve for WACC)
Take the weighted cost of equity (%) and add it to the weighted cost of debt (%).
WACC (%) = Weighted Cost of Equity (%) + Weighted Cost of Debt (%)
You now have the company’s weighted cost of capital (WACC), otherwise known as the discount rate.
PART III - TERMINAL VALUE OF PROJECTED CASH FLOWS
Now that you have the projected free cash flows for each year from PART I: Step 7, and the WACC from PART II: Step 12, you’ll need to calculate the terminal value of the company.
The most common method for calculating the terminal value is the perpetual growth model, which projects a discounted terminal value according to a constant growth rate.
The constant growth rate is the rate at which you can expect a company to grow in perpetuity after its growth period. This is important because it allows you to project the value of a company beyond the forecasted cash flows (3-5 years), which accounts for >50% of the total valuation.
As you can see, the relevance of the terminal value is it usually provides the bulk of the eventual valuation. Three to five years of future cash flows may add up to a sizable amount of a company’s valuation, but you still have to account for all the years after that.
That being said, projecting cash flows for 6 - ∞ years into the future would be as annoying as it is challenging, so this is where the perpetual growth rate comes into play. After your last projected year’s free cash flow, you’ll assume the company grows at a constant rate forever.
As might be expected, this is a big assumption, but companies don’t generally see double-digit growth for a very long time. If they stay in business, they eventually top out at a few percent each year, and that rate is the perpetual growth rate.
To calculate the terminal value, (1) take the furthest projected free cash flow, (2) multiply it by one plus the perpetual growth rate, and then (3) divide that by the difference between your discount rate (WACC) and the perpetual growth rate.
Terminal Value Perpetual Growth Rate Formula:
STEP 1 (Perpetual Growth Rate):
Calculate the perpetual growth rate (%). This is the average rate at which the economy is expected to grow in perpetuity.
There are two proxies for the perpetual growth rate: (1) the risk-free rate (10-year Treasury yield) and (2) the average national or global GDP.
For the latter approach, you can take the average GDP of your respective market (ex: US, UK, China, etc.) or the average global GDP for the last 10 - 20 years. This number is generally about 2.00% - 2.50%.
STEP 2 (Solve for Terminal Value)
(1) Take the furthest projected free cash flow from PART I: Step 7 (ex: year 5’s), (2) the perpetual growth rate from the previous step, and (3) the discount rate (WACC) from PART II: Step 12 and plug them into the terminal value formula to solve for TV.
TV = FCFn x (1 + Perpetual Growth Rate) ÷ (WACC - Perpetual Growth Rate)
You now have the terminal value of the company after the forecasted period.
PART IV - SOLVING FOR DCF VALUATION
STEP 1 (Discount Factor):
Take the discount rate (WACC), add one, and then raise that value to the power of n, where n is equal to the forecast year corresponding to each projected free cash flow.
As an example, if you forecasted free cash flows five years in the future, you would calculate this equation five times by raising the WACC plus one to the power of the corresponding year (ex: 1, 2, 3, 4, and 5).
The value returned for each year is the specific discount rate you will apply to that year’s projected free cash flow. Every year further into the future is discounted slightly more, hence raising the discount rate to a higher power each time.
Discount Factor = (1 + WACC)n
STEP 2 (Discounted Projected Free Cash Flow)
Take the projected free cash flows from PART I: Step 7 and divide them by their respective discount factors from the previous step to get each year’s discounted projected free cash flow (DCF).
DCFn = FCFn ÷ Discount Factorn
STEP 3 (DCF Valuation):
Take each of the discounted free cash flows from the previous step and the terminal value from PART III: Step 2 and add them all together to get the company’s DCF valuation.
DCF Valuation = DCF1 + DCF2 + …DCFn + TV
You now have a DCF valuation in terms of market capitalization based on the present value of the company’s projected free cash flows.
STEP 4 (Shares Outstanding):
Find the company’s total shares outstanding (#). This is available on Yahoo Finance, but you can also find this on most broker platforms, or in a company’s annual and quarterly reports (10-K and 10-Q) listed as “shares of common stock.”
STEP 5 (DCF Share Price):
Take the DCF Valuation from Step 3 (the DCF market capitalization) and divide it by the shares outstanding from Step 4 to get the company’s DCF share price.
DCF Share Price = DCF Valuation ÷ Shares Outstanding
You now have a DCF valuation in terms of share price based on the present value of the company’s projected free cash flows.
Congratulations on making it this far! I hope this walkthrough was helpful. If you have any questions or just want to connect, feel free to reach out to us via email (theinvestorsgate@gmail.com) or via Discord (link below).
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