Since the cash flows being discounted are “free” from the effects of financing and are available to both the debt and equity finance providers, the answer is equivalent to enterprise value. Since the financing of the operational business is provided by both debt and equity then the discount rate used is the weighted average cost of capital or WACC. These forecast cash flows and the terminal value are then discounted to present value using a discount rate that is commensurate with the risk associated with their generation. The steady state period also coincides with the end of the explicit forecast of the DCF analysis, and the value of steady state cash flows can be summarized in a single number, called the terminal value. The company reaches a steady state when all sources of competitive advantage are exhausted, and its profitability and efficiency ratios are stabilized. These cash flows, referred to as free cash flows or unlevered free cash flows, are generated by the operational business and available to all providers of finance.įree Cash Flows are generally forecast for five or ten years to steady state. The first step involves forecasting the cash flows to be discounted. Calculate implied share price from enterprise value using the bridge.Calculate Weighted Average Cost of Capital (WACC).Forecast free cash flows to steady state (normally 5 or 10 years).The process for undertaking a DCF analysis can be summarized by the following steps: The valuation is very dependent on key assumptions with even small changes producing large value variations Discounted Cash Flow Steps.It can take some time to build (depending on the detail).The requirement to make many assumptions about the business.It is cash flow based rather than earnings led.It is an important counterpoint to market-based valuation techniques (avoiding some of the possible market distortions).The requirement to think about and forecast key business drivers leads to a fuller understanding of the fundamentals.It is an absolute valuation methodology but should always be benchmarked against market valuation toolsĭCF analysis has both strengths and weaknesses.The model assumes that a large proportion of a company’s value is captured by the terminal value this is very sensitive to changes in growth rates.It relies on many assumptions and the valuation outcome is very sensitive to any changes in these.The method is cash flow based rather than focusing on earnings.It calculates the value of a business as the present value of the free cash flows it is expected to generate into the future. Discounted cash flow (DCF) analysis is a useful absolute valuation model in finance.
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