Valuation 101: How to do a discounted cashflow analysis

Sunday, Jan 22 2012 by

What is a DCF Valuation?

Discounted cash flow (DCF) analysis is a method of valuing the intrinsic value of a company (or asset). In simple terms, discounted cash flow tries to work out the value today, based on projections of all of the cash that it could make available to investors in the future. It is described as "discounted" cash flow because of the principle of "time value of money" (i.e. cash in the future is worth less than cash today).

The advantage of DCF analysis is that it produces the closest thing to an intrinsic stock value - relative valuation metrics such as price-earnings (P/E) or EV/EBITDA ratios aren't very useful if an entire sector or market is overvalued. In addition, the DCF method is forward-looking and depends more on future expectations than historical results. The method is also based on free cash flow (FCF), which is less subject to manipulatio than some other figures and ratios calculated out of the income statement or balance sheet.

DCF does however have its weaknesses as an approach. As it is a mechanical valuation tool, it is subject to the principle of "garbage in, garbage out". In particular, small changes in inputs can result in large changes in the value of a company, given the need to project cash-flow to infinity.  James Montier argues that, "while the algebra of DCF is simple, neat and compelling, the implementation becomes a  minefield of problems" (he cites, in particular, problems with  estimating cash flows and estimating discount rates). Despite the issues, DCF analysis is very widely used and is perhaps the primary valuation tool amongst the financial analyst community. As part of Stockopedia Premium, we provide pre-baked DCF valuation models for all stocks, which you can then modify with your own assumptions.

So how does it work?

In summary, the key steps in a DCF analysis are as follows:

1. Estimate Cashflows
2. Estimate Growth Profile (1 stage, 2 stage, 3 stage etc) & Growth Rates
3. Calculate Discount Rate
4. Calculate the Terminal Value
5. Calculate fair value of company and its equity

We explain each of these steps in more detail below.

1. How do we estimate base cashflow for a DCF?

In a DCF model, the first step is to estimate how much cash that the business will generate and could be paid to the investors.  In the…

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