Discounted Cash Flow Analysis
DCF valuation might be applied to any asset that generates positive free cash flow or is expected to generate that cash flow in the future. DCF valuation might be directly applied to stocks (equity cash flow method) or to entire company (firm’s cash flow method).
DCF valuation is not as popular as relative valuation, but still, most of the times, takes the main role among professional investors. Professionals like this method because of universality and scrupulosity.
However, for small retail investors DCF valuation might be not the best choice because this method requires a lot of time and knowledge to perform it. A very rough DCF valuation of one company may require day or two (including analysis of the company) while very detail valuation with all assumptions and market analysis may take weeks or even longer for a big company. Small business valuation can be made also using DCF method, even better than other valuation methods.
The principle of the DCF valuation is that free cash flows of the company have to be forecasted for all the future and discounted to its current value. In practice usually forecasted period is five years, and after five years residual value is added. The period of five years may be flexible depending on for how long you may predict future financial results with satisfactory precision.
I won’t include all the formulas of the calculation because I don’t see much practical value in that. Instead of it I will better include Excel spreadsheet ready for DCF calculation. The value of shares is equal to discounted cash flow (of forecasted period) value and discounted terminal value less net financial debt and minority share.
As you will see in the form, there are few main parts: cash flow prediction, terminal value calculation and discount rate prediction. Let’s go through practical aspects of those main parts.
Predicting the Cash Flow
As we talk about firm’s DCF valuation method, cash flow of the firm consists of several main parts (from assessor point of view):
- EBIT is earnings before interests (financial activity) and taxes. In DCF valuation EBIT is the main element that shapes the value for the company and its stocks. To forecast EBIT correctly you have to know the market and the company very well, as well, the whole country’s economy cannot be ignored. Usually EBIT is forecasted in two parts. Sales of the company and EBIT margin are forecasted for the same period. Then sales and profitability margin are multiplied in each year. Such forecast will be more accurate and reasonable. EBIT prediction is not an easy, and to make worthwhile forecasts the person that performs the valuation must be an expert of the industry sector, know the company and its competitors very well. Normally, market share should be forecasted too.
- Tax in the calculation should be effective corporate tax rate that applies for the company in that country. If company is international and has subsidiaries in many countries, you should adjust tax rate projections to that, especially, if sales proportions are tend to change regionally.
- Depreciation and amortization is quiet easy to predict when you know the details about company’s assets. It is more calculation that prediction. You have to calculate future’s depreciation according to held assets and accounting policy. Or you can do rough calculation according to total tangible assets and the practical depreciation rate for the last years.
- Changes in working capital are little bit harder to calculate, because if you want precision, you should forecasted whole balance sheet of the company. However, rough calculation can be made if sustaining the same ‘working capital / sales’ ratio. The more company is growing the stronger is need for working capital.
- Capital expenditures cannot be forecasted separately. It is very close to depreciation and sales. You have to know the capacity usage of the company and its needs for investments in tangible assets. If company’s assets are very old and depreciated it may need for big investments to replace that. Also if you are forecasting rapid growth of sales, but capacity usage is almost full, you will definitely need for huge investments in expansion of capacity.
Terminal value or residual value sometimes means very much. In many cases terminal value covers 60%-80% of total value. So it is critically important to calculate terminal value correctly, especially, for growth stocks. There are few main methods to calculate terminal value in stock valuation.
1. The most popular (also provided in spreadsheet DCF valuation example) method to calculate terminal value is to use capitalized free cash flow of the last forecasted year. What you have to do, is simply to take free cash of the last year, adjust working capital changes and capital expenditures according to terminal growth rate and divide the free cash flow by discount rate less terminal growth rate. Then terminal value is discounted to the current value.
2. If the forecasting of the terminal year cash flow is very problematic and very sensitive to the result, then valuation multiples (relative valuation) is used to determine terminal value. After that terminal value is discounted to the current value.
3. In some case liquidation value might be measured for terminal value calculation. If after some period all (or main part) of the assets is going to be sold on the market, then terminal value should be forecasted as price of those assets. And then terminal value has to be discounted to the current value.
Discount rate has critical importance for the result of the DCF valuation. Even few percent changes in discount rate might result totally different target price of the stock. In firm’s cash flow method the WACC (weighted average capital cost) is used as a discount rate. WACC is a weighted average between equity capital cost and borrowed capitals cost (cost of debt). Cost of debt is easier to measure, because it is equal to interest rate of listed company’s bonds. If there are no listed bonds of the company, debt cost may be measured according interest rates that are paid to the banks for loans (if there are no loans, you don’t need cost of debt) and changes in market conditions. Read more about cost of debt calculation.
However, it is much more problematic to find cost of equity. You may use the same spreadsheet to calculate it, but there are many sensitive details. All those details go in two parts: risk free interest rate and risk premium. Cost of equity should represent the same percent that investor would expect as annual return from investing in the valued stock. The mosrt proper way to calculate cost of equity is to use Capital Asset Pricing Model (CAPM).