DCF Valuation
DCF valuation, or discounted cash flow valuation, is a method used to estimate the value of an investment based on its expected future cash flows. It involves discounting these cash flows back to their present value using a discount rate, which reflects the investment's risk. DCF valuation is widely used in finance and investment analysis to determine the intrinsic value of a business or asset.
7 Key excerpts on "DCF Valuation"
eBook - ePubValuation
The Market Approach
- Seth Bernstrom(Author)
- 2014(Publication Date)
- Wiley(Publisher)
...Set out below is a brief introduction to these three methodologies. 1.1 THE DISCOUNTED CASH FLOW APPROACH The discounted cash flow approach (DCF) aims to establish the net present value of a cash flow generating asset (e.g. a company) by discounting its future expected returns with an appropriate required rate of return. Performing business valuations, the cash flow which forms the basis of the net present value calculation is usually the “free cash flow to firm” (FCFF), explicitly the expected cash flow of the business independent of its financing (i.e. cash flow accruing to the company’s shareholders and lenders). Consequently, the cash flow in question should not be affected by such things as interest or dividends; however, it will be burdened by tax. Hence, the discount rate must reflect a weighted cost of capital for debt and equity financing after tax. A discounting (i.e. a net present value calculation) of the expected cash flow at the appropriate weighted average cost of capital will give the value of the business enterprise (i.e. the market value of operating capital or, alternatively, the market value of invested capital). To obtain the value of the shares, i.e. the value of the equity, the business enterprise value needs to be adjusted by the net debt position at the valuation date, i.e. subtracting financial liabilities, and including excess cash and non-operating assets. It is also possible to compute the equity value, i.e. the market value of all shares, via a direct approach, that is, by projecting future cash flow specifically attributable to the shareholders of the company, free cash flow to equity (FCFE). Such cash flow has already been charged with financial items (interest and suchlike) and should accordingly be discounted by a matching rate of return (specifically a required return on equity)...
eBook - ePubInvestment Valuation
Tools and Techniques for Determining the Value of Any Asset
- Aswath Damodaran(Author)
- 2012(Publication Date)
- Wiley(Publisher)
...To do relative valuation correctly, we need to understand the fundamentals of discounted cash flow valuation. To apply option pricing models to value assets, we often have to begin with a discounted cash flow valuation. This is why so much of this book focuses on discounted cash flow valuation. Anyone who understands its fundamentals will be able to analyze and use the other approaches. This section considers the basis of this approach, a philosophical rationale for discounted cash flow valuation, and an examination of the different subapproaches to discounted cash flow valuation. Basis for Discounted Cash Flow Valuation This approach has its foundation in the present value rule, where the value of any asset is the present value of expected future cash flows on it. where n = Life of the asset CF t = Cash flow in period t r = Discount rate reflecting the riskiness of the estimated cash flows The cash flows will vary from asset to asset—dividends for stocks, coupons (interest) and the face value for bonds, and after-tax cash flows for a real project. The discount rate will be a function of the riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer projects. You can in fact think of discounted cash flow valuation on a continuum. At one end of the spectrum you have the default-free zero coupon bond, with a guaranteed cash flow in the future. Discounting this cash flow at the riskless rate should yield the value of the bond. A little further up the risk spectrum are corporate bonds where the cash flows take the form of coupons and there is default risk. These bonds can be valued by discounting the cash flows at an interest rate that reflects the default risk. Moving up the risk ladder, we get to equities, where there are expected cash flows with substantial uncertainty around the expectations...
eBook - ePubEarly Stage Valuation
A Fair Value Perspective
- Antonella Puca(Author)
- 2020(Publication Date)
- Wiley(Publisher)
...CHAPTER 6 Discounted Cash Flow Method John Jackmanand Antonella Puca The discounted cash flow (DCF) method is an income-based approach in which enterprise value is estimated based on the present value of the company's expected cash flows, discounted at a rate that reflects the risk of these cash flows. The credibility of the DCF method lies in a reliable cash flow forecast and well-developed discount rates. The estimate of a discount rate that considers both the prospective of the firm in acquiring its capital resources (cost of capital) and of market participants in pursuing their risk/return objectives (rate of return) is an important step in ensuring that a DCF model for an early stage enterprise (ESE) is reasonable and consistent with fair value principles. This chapter develops a DCF model to estimate enterprise value under the fair value standards of ASC 820/IFRS 13, using a venture-backed ESE as an example. After presenting the model's components and key assumptions in some detail, the chapter shows how a DCF model can be built to reflect the special characteristics of an ESE using a scenario analysis to account for the company's risk of failure. We then discuss how a DCF model can be calibrated to estimate the fair value of the enterprise in subsequent measurement. 1 As we walk through our model, we highlight some key considerations concerning the valuation process and the documentation requirements under the Mandatory Performance Framework (MPF). 2 In his studies of early stage valuation, Aswath Damodaran has underlined the importance of developing a realistic and internally consistent narrative on the company's path to profitability and to a stage of sustainable long-term growth. The company's narrative should translate into valuation inputs and numbers in a model that can be adjusted at subsequent measurement dates as the company and market environment continue to evolve. 3 In our example, Racoon Inc...
eBook - ePubQuantitative Finance
A Simulation-Based Introduction Using Excel
- Matt Davison(Author)
- 2014(Publication Date)
- Chapman and Hall/CRC(Publisher)
...Chapter 4 Valuing Investment Opportunities The Discounted Cash Flow Method 4.1 CHAPTER SUMMARY As mentioned in the introduction, finance involves return, risk, and time. For many years, projects carried out over multiple years with uncertain cash flows were evaluated using the so-called discounted cash flow method, also known as the present value of the expected value method. This method is conceptually very straightforward. Cash flows are assumed to occur at finitely many discretely spaced time periods. The size of the cash flow D k at each period is a random variable with known probabilities P k (D k). The expected value of these random variables E (D k), is computed at each time period. Cash flows at different times are compared by using a discount rate ρ to bring them all to a common baseline at time t 0. If the aggregate value of all the expected values at that baseline is positive, then the project is a good one and should be initiated; if it is negative, it is a poor project and should be avoided. Of course, the choice of the discount factor is very important here. In this chapter, we present some examples of this and discuss the pros and cons of this decision approach. 4.2 Discounted Cash Flow Method for Evaluating Investment Opportunities 4.2.1 Example of a Discounted Cash Flow Technique Suppose you are offered the following investment: For an investment of $1000 today, you receive cash flows after 1, 2, and 3 years. Each year, you receive either $500 (with an 80% chance) or $200 (with a 20% chance). Your company has set a “hurdle rate” of 10% for risky investments. Should you make the investment or not? The discounted cash flow (DCF) method proceeds as follows...
eBook - ePub- Alan Millington(Author)
- 2013(Publication Date)
- Estates Gazette(Publisher)
...Their use will not necessarily give better or more accurate results, as much will depend upon the skill and judgement of the person doing the calculations, the results obtained from the calculations being very much dependent upon the various assumptions made by the user. Table 19.5 Example 7 However, it is probably true to say that where a calculation or valuation is dependent upon a considerable number of variables and a large number or varying pattern of time periods, the use of discounted cash flow techniques is more appropriate than the traditional investment valuation approach. It is also easy to incorporate in discounted cash flow calculations estimates to reflect the effect of inflation upon future income flows and outgoings. Likewise, whereas traditional methods cannot easily reflect the possibility of the future sale of the income producing asset at an enhanced value, such a calculation is easily incorporated in a discounted cash flow calculation. (The reader should not overlook the fact that it may in some instances be necessary to allow for future decreases in income or value.) In this respect discounted cash flow techniques are particularly useful as they facilitate the estimation of a true return over time allowing for changes in value and liabilities over the time period. The traditional valuation approach generally assumes a rate of return and utilises estimates of returns and liabilities at figures appropriate at the time the valuation is made and consequently is not likely to give an indication of the true return to an asset over the period of ownership. Advocates of the use of the DCF approach for all valuations stress the ability to easily incorporate future variations in income, outgoings, or yields into the calculations, something which is not so easily done with the conventional investment (or capitalisation) approach...
eBook - ePub- Frank J. Fabozzi, Frank J. Fabozzi(Authors)
- 2012(Publication Date)
- Wiley(Publisher)
...In other words, a precondition for market efficiency seems to be the existence of millions of investors who believe that markets are not. Stock-pricing models are not physical or chemical laws of nature. There is, however, a strong principle of investing that must eventually hold true for all firms over time if they are to have a positive value. This principle is that you should always be able, in your mind, to construct some sort of logical connection between a positive stock price today and a stream of future cash flows to the investor. The logical chain might be long. You might assume that years of start-up losses (earnings are zero or negative) will be followed by more years of all profits being reinvested. But you should be able to envision some connection between today’s positive stock price and a stream of cash flows that will commence someday in the future. In this entry, we discuss practical methods of valuing a firm’s equity based on discounted cash flow (DCF) models. Although stock and firm valuation is very strongly tilted toward the use of DCF methods, it is impossible to ignore the fact that many analysts use other methods to value equity and entire firms. The DCF model is the subject of this entry. The primary alternative valuation method is relative valuation (RV). Both DCF and RV valuation methods require strong assumptions and expectations about the future. No one single valuation model or method is perfect. All valuation estimates are subject to model error and estimation error. Nevertheless, investors use these models to help form their expectations about a fair market price. Markets then generate an observable market clearing price based on investor expectations, and this market clearing price constantly changes along with investor expectations. DIVIDEND DISCOUNT MODEL The dividend discount model (DDM) is the most basic DCF stock approach to equity valuation, originally formulated by Williams (1938)...
eBook - ePubThe Five Rules for Successful Stock Investing
Morningstar's Guide to Building Wealth and Winning in the Market
- Pat Dorsey(Author)
- 2011(Publication Date)
- Wiley(Publisher)
...In all three examples—StableCorp, CycliCorp, and RiskCorp—the sum of the undiscounted cash flows is about $32,000. However, the value of the discounted cash flows is quite different from company to company. In present value terms, CycliCorp is worth about $2,700 less than StableCorp. That’s because StableCorp is more predictable, which means that investors’ discount rate isn’t as high. CycliCorp’s cash flow increases by 20 percent some years and shrinks in some years, so investors perceive it as a riskier investment and use a higher discount rate when they’re valuing its shares. As a result, the present value of the discounted cash flows is lower. The difference in the present value of the cash flows is even more acute when you look at RiskCorp, which is worth almost $8,300 less than StableCorp. Not only are the bulk of RiskCorp’s cash flows far off in the future, but also, we’re less certain that they’ll come to pass, so we assign an even higher discount rate. Believe it or not, you now know the basic principles behind a discounted cash flow model. Value is determined by the amount, timing, and riskiness of a firm’s future cash flows, and these are the three items you should always be thinking about when deciding how much to pay for a stock. That’s all it really boils down to. Calculating Present Value Now that you know the theory behind an intrinsic value calculation, here’s how you can do it in practice. To find the present value of a $100 future cash flow, divide that future cash flow by 1.0 plus the discount rate. Using a 10 percent discount rate, for example, a cash flow of $100 one year in the future is worth $100/1.10, or $90.91. A $100 cash flow two years in the future is worth $100/(1.10) 2, or $82.64. In other words, $82.64 invested at 10 percent becomes $90.91 in a year and $100 in two years...
