Discover the specifics of using Discounted Cash Flow (DCF) model, a valuation method utilized for estimating a company's value based on its projected future cash flows. Learn the steps involved in DCF modeling, from deriving historical information from financial statements to calculating equity value per share, to effectively value a company.
Key Insights
- Discounted Cash Flow (DCF) is a valuation method used to estimate the value of a company based on its expected future cash flows, thus providing a present value of the company.
- The first step in DCF modeling is to derive necessary historical financial information from financial statements, which is then used to calculate Free Cash Flows of the company.
- Historical value drivers are calculated and listed for use in the model based on historical line items.
- Assumptions for projected value drivers are made using historical data and other relevant information from MD&A and footnotes sections of the 10-K.
- Projected line items for the model are calculated based on historical data and projected value drivers.
- The final goal of DCF modeling is to calculate Equity Value per share, which is the culmination of all previous steps.
DCF Model Build
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Project Free Cash Flows
5-10 years of unlevered FCF based on operating assumptions.
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Calculate Terminal Value
Gordon growth or exit multiple beyond projection period.
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Discount at WACC
Each year's FCF discounted to present value at the cost of capital.
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Sum to Get Enterprise Value
Adjust for net debt to get equity value.
DCF Model overview and steps
Discounted cash flow (DCF) is a valuation method used to estimate the value of the company based on its expected future cash flows. DCF analysis attempts to figure out the value of the company today, based on projections of how much money it will generate in the future.
Step 1. Derive historical information from financial statements.
The first step in any financial model is to derive necessary information from financial statements. We need to create historical data in the spreadsheet with the model. Then we need to calculate the necessary totals. And after—we calculate Free Cash Flows, which is the gross free cash flow generated by a company.
Step 2. Calculate Historical Value Drivers
Next, we need to create a list of historical value drivers to use in our model and calculate them based on the historical line items above.
Step 3. Make Assumptions for the Projected Value Drivers
We can use historical data for that and also any helpful information in the MD&A and footnotes sections of the 10-K. Also, you can do additional research for the industry to make sure your assumptions make sense.
Step 4. Calculate Projected Line Items for the Model.
Calculating based on historical data and projected value drivers we did input and calculated in the previous step.
Step 5. Calculate Equity Value per Share
The final step and final goal of DCF modeling is to find equity value per share.
In the Upcoming Videos, We’ll Build This Simple DCF Model Step by Step.
Some of the points that you need to remember:
- There are limitations in terms of using DCF. Primarily that it relies on estimations of future cash flows. That could prove to be inaccurate.
- At the same time, DCF is a simple and effective way to value the company.
Video Transcription:
Full Video Transcript
Discounted cash flow is a valuation method used to estimate the value of the company based on its expected future cash flows. DCF analysis attempts to figure out the value of the company based on projections of how much money it will generate in the future. Let's discuss the logic of building a DCF financial model.
Gathering Historical Financial Data
The very first step would be to derive historical information from financial statements. We need to create historical data in the spreadsheet with a model and then calculate the necessary totals. After that, we need to calculate free cash flows, which is the gross free cash flow generated by the company.
In the second step, we need to create a list of historical value drivers to use in our model and calculate them based on historical line items above.
Making Projections and Assumptions
In step three, we make assumptions for the projected value drivers. We can use historical data for that and also any helpful information in MD&A and footnote sections of the 10-K of the company. Also, you can do additional research for the industry to make sure your assumptions make sense.
Step number four is to calculate projected line items for the model based on historical data and projected value drivers we did input and calculated in the previous steps. The final step of our DCF model is to find the equity value per share. In the next videos, we'll build this simple DCF model step by step.
DCF Model Limitations and Benefits
There are some points that you need to remember when building a DCF model. There are limitations in terms of using DCF, primarily that it is very sensitive to our estimations of future cash flows, and that could prove to be inaccurate in some cases. At the same time, DCF model uses intrinsic value of the company and it's a simple method to value the company.
