The discounted cash flow model, commonly referred to simply as “DCF”, is one of the most used methods to value a company. This kind of analysis is so powerful that it can be used for any kind of company, whether public or not. The DCF, as most of the investment valuation models, relies on the time concept, meaning that the value of money declines as it goes further in time, and basically discounts the future inflows of money by a certain value, called “discount rate”, to get the net present value (NPV) of those projected cash flows. When applied to public companies, the DCF typically discounts the future free cash flows (FFCF) by the weighted average cost of capital (WACC).
The concept of DCF valuation is based on the principle that the value of a business, or an asset, is inherently based on its ability to generate cash flows for the providers of capital. Therefore, the model relies more on the fundamental expectations of the business, than on public market factors or historical precedents, and it is a more theoretical approach relying on numerous assumptions.
It sounds difficult, but it really isn’t. The company evaluation through the DCF involves several steps:
Estimating the income statement
Estimating the balance sheet
Estimating free cash flow
Estimating terminal value and terminal growth rate
Discounting future cash flows
After having completed these steps, the end result is the overall value of a business, including both debt and equity. Then, to get the fair value per share, all we’ll have to do is simply to divide that result by the number of total shares outstanding. Let’s examine each step in detail.
Estimating the income statement
The first and most important step of the process it to estimate the future revenues of the company. There are several ways to do it, depending on the degree of precision needed: for example, you could look what analysts are estimating as revenue growth, or you could use an average of the company’s revenue growth in the past. Another way to estimate future revenues is to look at what management is saying in their forward-looking statements: however, while nobody knows a company better than its managers, more often than not those data is downplayed to leave shareholders surprised at quarterly and annual results. At Blackink Research, we estimate future revenues by modelling the market share expansion, the industry value and socio-economic factors.
After having estimated the revenues, you should estimate each other non-unusual item present in the income statement. Some items are easier than others to estimate: for example, the income tax expense is calculated as the product between the earnings before taxes and the effective tax rate. To estimate the future tax rate, you have multiple options: you can either use an average of the historical ones, you can use the previous year’s one and keep it fixed at that value, you can use the base corporate tax rate for companies in that country, or you could create an entire model just for that rate. Whatever your choice, we’d suggest keeping the valuation model simple: this way, it’s easier to adjust, modify, correct or maintain.
Other items require more attention and need to be modeled carefully. For example, the cost of good sold (COGS) is directly correlated with the revenue amount, therefore we can estimate it as a percentage of revenue. For all other items, it’s important that the analyst is able to find the correct value driver of that items, like revenue was for COGS, and estimate it accordingly.
Basically, forecasting the income statement involves three steps:
Deciding what economic relationships drive the line item. For most line items, forecasts will be tied directly to revenues, but some lines will be economically tied to specific assets or liabilities.
Estimating the forecast ratio, that is the ratio between the item and its driver. For each line item on the income statement, you should compute historical values for each ratio, followed by estimates for each of the forecast periods.
Multiplying the forecast ratio by an estimate of its driver. For example, in the case of COGS, you multiply its forecast ratio by the estimate for revenues that year. Ratios dependent on other drivers should be multiplied by their respective ratios. Since most line items are driven by revenues, it’s critical to have a good revenue forecast: otherwise, any error will be carried through the entire model.
Estimating the balance sheet
To estimate the balance sheet, the method is really similar to the one used in estimating the income statement, with one caveat: it needs to balance. Recall the fundamental accounting equation:
Assets = Liabilities + Equity
Our model must respect that equation.
One critical decision that has to be made when estimating the balance sheet items is whether to forecast them directly or indirectly by forecasting the year-to-year changes in accounts. For example, the first approach forecasts receivables as a function of revenues, while the second one forecasts the change in receivables as a function of the growth in revenues. At Blackink Research, we use the first method, as the relationship between the balance sheet accounts and drivers is more stable than that between balance sheet changes and changes in revenues.
To ensure that the equation is respected, it’s usually left one item, commonly excess cash, as simply the value needed to balance things out.
Estimating the free cash flow
After having estimated the balance sheet, we can do the same for the operating section of the statement of cash flows. We need to remember that depreciation is driven by net property, plant and equipment while amortization is driven by intangibles.
We now have all what’s needed to calculate the free cash flow. The free cash flow is the cash a company generates after taking into consideration cash outflows that support its operations and maintain its capital assets. Basically, we can say that the free cash flow is nothing more than the cash remaining after having paid both for operating expenses and capital expenditures. There are several ways to calculate the free cash flow, depending on the degree of precision the analyst wants to have, but the most common one is the following:
Free cash flow = Cash Flows from Operations – Capital Expenditures
No matter what method it is used to calculate the free cash flow, the result should be the same, if there are no errors or approximations involved. Cash Flows from Operations is calculated as the net income adjusted for changes in net working capital and noncash expenses, such as depreciation and amortization.
Cash Flows from Operations = Net Income + ΔNet Working Capital – Noncash expenses
Capital Expenditures is calculated as the changes in net property, plant and equipment adjusted for depreciation. For example, for fiscal year 2022, the calculation would be the following:
Capital Expenditures = Net PP&E (2022) – Net PP&E (2021) + Depreciation (2022)
After having calculated the free cash flow for the entire forecast period, we can move to the calculation of the weighted average cost of capital, since it will be used as the discount factor in the net present value calculation.
Calculating the weighted average cost of capital (WACC)
The WACC is the firm’s average cost of capital from all sources, including common stock, preferred stock, bonds and other forms of debt. The WACC is commonly used as a discount rate when using the DCF model to evaluate companies as it expresses, in a single number, the return that both bondholders and shareholders demand in order to provide the company with capital. Usually, higher WACC is assigned to highly volatile companies or companies that are seen as risky, as investors will demand greater returns.
The formula for the WACC is relatively simple, as it multiplies the cost of both forms of capital by their own cost:
E represents the value of equity, also known as “market capitalization”.
D represents the total debt. This value is sometimes expressed in the notes to financial statements, but more often than not it needs to be calculated.
V represents the sum of total equity and total debt
Ke represents the cost of equity. This value can be hard to calculate, since share capital doesn’t have an explicit value. As a result, you either estimate the rate of return that investors demands based on the expected volatility of the stock, or you use some specific models such as the Capital Asset Pricing Model, also referred to as CAPM. At Blackink Research, we chose the latter solution.
Kd represents the cost of debt. For public companies, this value is calculated by simply dividing the interest expenses incurred by the company by their total debt. Sometimes, public companies include the cost of debt directly in their filings. For private companies it is a bit harder to get this value, but one can look at the company’s credit rating from firms like Moody’s, S&P or Fitch, and then adjust for a relevant spread over risk-free assets to approximate the required rate of return demanded by investors.
Tc represents the effective tax rate. Since companies are able to deduct interest expenses from their taxes, the debt cost needs to be adjusted for the amount saved in taxes.
Estimating the terminal value and the terminal growth rate
Since it’s impossible to estimate too many years in the future without losing precision or reliability, we have to have an estimated value for all the business activities beyond that point. This is the terminal value, the value of an asset, business or project beyond the forecasted period when future cash flows can be estimated. In order to calculate the terminal value, it is assumed that the company will grow at a set growth rate forever after the forecast period, reason why usually this value represents a large portion of the total assessed value.
At Blackink Research, we usually have a forecast period of 10 years. However, this can be lower for smaller companies subjected to high-growth, as it can be higher for big established companies characterized by stable and low growth.
The terminal value is calculated this way:
Where g is the perpetual terminal growth rate after the year n. The terminal growth rate typically reverts to the industry growth rate very quickly, and few companies can be expected to grow faster than the economy for long periods. Therefore, usually the best estimate for this value is the expected long-term rate of consumption growth for the industry products, adjusted for inflation. Other times, a good estimate of the terminal growth rate is simply given by the GDP growth forecasts.
One common error when considering the terminal value is thinking that the length of the forecast period influences the valuation result. Indeed, while the length of the explicit forecast period chosen is important, it doesn’t affect the value of the company, but rather only the distribution of the company’s value between the explicit forecast period and the years that follow. As the explicit forecast horizon grows longer, value shifts from the continuing value to the explicit forecast period, but the total value remains the same.
Discounting future cash flows
The last step needed to evaluate a company using the discounted cash flow model is to discount the future cash flows. Recall the formula for the net present value of an investment:
Where n is the year under consideration, r is the discount rate, and CF is the cash flow for that year. We can easily adjust this formula for our data by using our previously calculated free cash flows as numerator and weighted average cost of capital as denominator. The terminal value will use the same discount rate as the last year. Then, for every year, we calculate the net present value.
Finally, to calculate the value of the company, you need just to sum all the present values. To get the fair value per share, or the price at which the company’s stocks are correctly priced according to your assumptions, you just need to divide the value of the company by the number of shares outstanding. Voilà, you completed the valuation!
Valuing a company is necessary in order to make smart and profitable investments. However, since it relies on many assumptions that are difficult to estimate correctly, it can be a hard work for non-professionals and people outside the financial industry.
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