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What is Discounted Cash Flow (DCF) Model?

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The discounted cash flow model is a financial model that discounts projected unlevered free cash flows to their net present value (NPV). It uses a discount rate to derive NPV. The logic behind this is that a dollar today has more value than a dollar received in the future. DCF considers risk and opportunity for an investment. The further it is to the future, the riskier the investment. It needs to be discounted more to its present value.

As discussed above, DCF Model uses unlevered cash flow to compute for NPV. Unlevered free cash flows are cash flows available to the firm before deducting the financial obligations. This cash flow is available both for debt holders and investors to a company. Unlevered free cash flow opts more than net income since cash flow shows the economic value. It depicts the available cash to pay for the company's debtors, investors, or money invested back to the business. A company can generate profit based on its financial statement, but accounting profit does not mean much without the cash to finance the operations.

What are the Steps in Creating a DCF Model?

To create any financial model, you need first to establish the necessary schedules and three financial statements and then use the available projected numbers to compute for the DCF Model.

1.            Projecting Revenue

A manufacturing company's revenue projection is to multiply production volume to its price, then project increase based on historical data and management's target revenue. For a more complicated business such as SaaS businesses, there are different factors to consider, such as the monthly/annual recurring revenue, average revenue per user, and the churn rate.

2.            Estimating Expenses

The most common costs and expenses are raw materials, salaries and wages, overhead, and general and selling expenses. Projections are based on the expected inflation rate.

3.            Forecasting Changes in Net Working Capital and CAPEX

Accounts receivable, inventory, and account payables changes are either added or subtracted depending on their cash impact. Assets schedules are prepared separately to compute each asset acquisition cost, depreciation, and net value then consolidated in a summary schedule.

4.            Preparing Debt Schedules

Debt schedules are prepared for each debt source to compute for the individual interest payable and repayment. Total financial obligations are then linked to the balance sheet liabilities section.

5.            Computing for Terminal Value

There are two ways to compute for terminal value: perpetual growth rate and exit multiple approaches. The perpetual growth rate approach assumes that the cash flow at the end of the projected period increases at a constant rate for perpetuity. For example, if the 10th year (end of the projected year) is $12 million, a growth rate of 2.5%,  and an expected return of 8%. The terminal value computed is $181.8 million (10 million / (8%-2.5%)).

Exit multiple expects that a company will be sold at the end of the forecasted year. It uses the EV/EBITDA multiple of a currently sold comparable. If the multiple is 8.5x, multiply it to 7 million cash flow, gives a terminal value of 59.5 million (7 million x 8.5).

Terminal value is then discounted back to its net present value.

6.            DCF Enterprise Value

In preparing for the DCF Model, the computed net present value is the enterprise value. Enterprise value is the basis for valuing a business or comparing it to a similar company. Since DCF uses the unlevered free cash flow, the computation of enterprise value disregards the capital structure.

7.            Equity Value

To compute the equity value, take the NPV and adjust for cash & cash equivalent and financial debt. The value is then divided by the number of outstanding shares to get the price per share.

By doing the above requirements, you can now have the necessary figures to evaluate the business' profitability, enterprise value, equity value, and other metrics to help you decide if to pursue a project or not.

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