# Valuation using discounted cash flows

Valuation using discounted cash flows

Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream after the forecast period.

## Basic formula for firm valuation using DCF model

value of firm = $\sum_{t=1}^n \frac{FCFF_t}{(1+WACC_{hg})^t} + \frac{\left[\frac{FCFF_{n+1}}{(WACC_{st}-g_n)}\right]}{(1+WACC_{hg})^n}$

where

## Process Data Diagram

The following diagram shows an overview of the process of company valuation. All activities in this model are explained in more detail in section 3: Using the DCF method.

## Using the DCF Method

### Determine Forecast Period

The forecast period is the time period for which the individual yearly cash flows are input to the DCF formula. Cash flows after the forecast period can only be represented by a fixed number such as annual growth rates. There are no fixed rules for determining the duration of the forecast period.

Example:

‘MedICT’ is a medical ICT startup that has just finished their business plan. Their goal is to provide medical professionals with software solutions for doing their own bookkeeping. Their only investor is required to wait for 5 years before making an exit. Therefore MedICT is using a forecast period of 5 years.

### Determine the yearly Cash Flow

Cash flow is the difference between the amount of cash flowing in and out a company. Make sure to consistently include the different types of cash flows.

Example: MedICT has chosen to use only operational cash flows in determining their estimated yearly cash flow:

In thousand €

 Year 1 Year 2 Year 3 Year 4 Year 5 Revenues +30 +100 +160 +330 +460 Personnel -30 -80 -110 -160 -200 Car Lease -6 -12 -12 -18 -18 Marketing -10 -10 -10 -25 -30 IT -20 -20 -20 -25 -30 Cash Flow -36 -22 +8 +102 +182

### Determine Discount Factor / Rate

Determine the appropriate discount rate and discount factor for each year of the forecast period based on the risk level associated with the company and its market.

Example:

MedICT has chosen their discount rates based upon their company maturity.

 Year 1 Year 2 Year 3 Year 4 Year 5 Risk Group Seeking Money Early Startup Late Start Up Mature Risk Rate 50 - 100 40 – 60 30 – 50% 10- 25% Discount Rate 65% 55% 45% 35% 25% Discount Factor 0.61 0.42 0.33 0.30 0.33

### Determine Current Value

Calculate the current value of the future cash flows by multiplying each yearly cash flow by the discount factor for the year in question. This is known as the time value of money.

Example:

 Year 1 Year 2 Year 3 Year 4 Year 5 Cash Flow -36 -22 +8 +102 +182 Discount Factor 0.61 0.42 0.33 0.30 0.33 Current Value € -21.96 € -9.24 € 2.64 €30.6 €60.1

Total current value = 62.14

### Determine the Continuing Value

Calculating cash flows after the forecast period is much more difficult as uncertainty, and therefore the risk factor, rises with each additional year into the future. The continuing value, or terminal value, is a solution that represents the cash flows after the forecast period.

Example:

MedICT has chosen the perpetuity growth model to calculate the value of cash flows after the forecast period. They estimate that they will grow at about 6% for the rest of these years.

(182*1.06 / (0.25-0.06)) = 1015.34 This value however is a future value that still needs to be discounted to a current value: 1015.34 * 1/(1.25)^5 = 332.72

### Determining Equity Value

The value of the equity can be calculated by subtracting any outstanding debts from the total of all discounted cash flows.

Example:

MedICT doesn’t have any debt so it only needs to add up the current value of the continuing value and the current value of all cash flows during the forecast period:

62.14 + 332.72= 394.86 The equity value of MedICT : € 394.86

## Literature

• Kubr, Marchesi, Ilar, Kienhuis. 1998. Starting Up. Mckinsey & Company
• Pablo Fernandez. 2004. Equivalence of ten different discounted cash flow valuation methods. IESE Research Papers. D549
• Ruback, R. S., 1995, An Introduction to Cash Flow Valuation Methods, Harvard Business School Case # 295-155.
• Keck, T., E. Levengood, and A. Longfield, 1998, Using Discounted Cash Flow Analysis in an International Setting: A Survey of Issues in Modeling the Cost of Capital, Journal of Applied Corporate Finance, Fall, pp. 82–99.
• Aswath Damodaran 2001 Investment Valuation: Tools and Techniques for Determining Value. Wiley
• McKinsey & Co., Tim Koller, Marc Goedhart, David Wessels. 2005. Valuation: Measuring and Managing the Value of Companies. John Wiley & Sons.

Wikimedia Foundation. 2010.

### Look at other dictionaries:

• Discounted cash flow — Excel spreadsheet uses Free cash flows to estimate stock s Fair Value and measure the sensibility of WACC and Perpetual growth In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts… …   Wikipedia

• Discounted Cash Flow - DCF — A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive… …   Investment dictionary

• discounted cash flow — A technique or process for valuing a financial instrument by applying a discount rate (or a series of discount rates) to calculate a present value of each future interest and principal cash flow expected from a financial instrument. The sum of… …   Financial and business terms

• Valuation (finance) — Accountancy Key concepts Accountant · Accounting period · Bookkeeping · Cash and accrual basis · Cash flow management · Chart of accounts  …   Wikipedia

• Stock valuation — There are several methods used to value companies and their stocks. They attempt to give an estimate of their fair value, by using fundamental economic criteria. This theoretical valuation has to be perfected with market criteria, as the final… …   Wikipedia

• Business valuation — is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a… …   Wikipedia

• Real options valuation — Real options valuation, also often termed Real options analysis,[1] (ROV or ROA) applies option valuation techniques to capital budgeting decisions.[2] A real option itself, is the right but not the obligation to undertake some business decision; …   Wikipedia

• Free cash flow — In corporate finance, free cash flow (FCF) is a cash flow available for distribution among all the security holders of a company. They include equity holders, debt holders, preferred stock holders, convertibles holders, and so on.There are two… …   Wikipedia

• Datar-Mathews Method for Real Option Valuation — The Datar Mathews Method [1] (DM Method ©[2]) is a new method for Real options valuation. The DM Method can be understood as an extension of the net present value (NPV) multi scenario Monte Carlo model with an adjustment for risk aversion and… …   Wikipedia

• Bond valuation — is the process of determining the fair price of a bond. As with any security or capital investment, the fair value of a bond is the present value of the stream of cash flows it is expected to generate. Hence, the price or value of a bond is… …   Wikipedia