Discounted Cash Flow (DCF) Valuation

DCF methodology is used to calculate intrinsic value of company based on its capacity to generate
future cash flows. It is one of the most precise method to calculate the fundamental value of any
business. But, DCF is very tricky as it is based on hundreds of assumptions. Industry’s most used
methodology, DCF deserves some analysis to understand its benefits and shortcomings.

Advantages of DCF

 Universal Usage: DCF can be used to determine value of any business even if it has no
historical peers and no comparable information is available
 Forward Looking methodology: It depends upon future capability of earnings and does not
depend upon historical results
 Free from short term market influence and Non-economic factors: DCF derives the intrinsic
value of business and its future potential. Moreover, it takes all these political, business
coefficients into consideration while calculating DCF. So, DCF is free from the market
conditions and other factors which are not directly linked with company’s performance
 Dependence on Cash Flow generation: It is based on Free Cash Flows generated by the
business, which has high reliability and eliminates any accounting tricks and subjectivity

Pitfalls of DCF

 Game of Assumptions: Everything can be summed up by a proverb “Garbage In – Garbage

Out”. So, everything about DCF boils down to the quality of assumptions. There is a lot of
subjectivity to the assumptions which leads to highly sensitive output.
 Forecasting Future Performance: DCF is the best technique if you know your future cash
flows, but predicting future cash flows is a very difficult task. Also, most of the companies
don’t work with 100% transparency which makes the task of forecast even more difficult.
 Time Sensitiveness of result: It is most time sensitive valuation methodology as it depends
on the free cash flows and there timing. Discounting these free cash flows at different
periods make a difference from buying a company or selling a company

DCF is a very thorough and exact valuation methodology, but it should be used where you can
predict the future cash flows with some level of confidence. It should never be used for valuing
companies which are at very early stage, as there is no visibility of revenues and costs for such
companies. DCF should always be used with the Relative Valuation Methodologies for doing the
sanity check.

It involves calculating future free cash flows and then discounting them at Weighted Average Cost of
Capital (WACC) to get EV.

Steps of value determination

a) Forecasting Financials for next 5-10 years: Please find below details of the key items which are
required to be forecasted to calculate future free cash flows.
 i. Revenues: There are multiple techniques which can be used to forecast future revenues
like forecast based on past growth rates, forecast based on manufacturing capacity,
forecast based on past market share, forecast based on industry growth
o Forecast based on growth rates: This is one of the easiest method to forecast
revenues. In this methodology past 3-4 years’ revenue growth is calculated and
based on its trend forecasting is done. This technique is primarily used in case of
services’ companies, where there are no or negligible tangible assets.
o Forecast based on manufacturing capacity: In this methodology, revenues are
forecasted based on company’s production/ manufacturing capacity. Correlation is
determined between past production capacity and revenue, which is used to
forecast the future revenues. If the future manufacturing capacity is not planned to
be changed as per management, then the capacity is assumed to increase as per
previous growth trends.
o Forecast based on market share: This methodology is used for companies which
have considerable market share in their industry. Correlation is determined between
past market share of company in previous years and revenue. Also, from industry
research reports future market size is determined. These two factors are then used
to forecast the future revenues.
o Forecast based on industry growth: This technique is primarily used for industries
which are very new and in nascent stage or companies for which past financial data is
not available. As, past trends are very difficult to determine for the companies
operating in these industries. Industry growth are determined from broker research
reports or industry research reports. Then this growth rate is used to project future
cash flows.

ii. Costs including Direct costs, Sales & Marketing costs and General & Administrative
costs: Most used methodology worldwide is % revenue technique. In this methodology
different costs heads are forecasted on basis of past years’ % revenue. As any cost is used
to drive revenue, so any change in revenue should also be reflected in costs. This reason
gives the credibility to this methodology:
o % Revenue Technique: For all the costs heads, costs as % revenues are calculated for
previous years. Now on basis of % revenue trend for each cost head future % revenue
is determined using trend analysis. Then these % revenues are used to calculate the
future costs.
iii. Depreciation and Amortization (D&A) and Capital Expenditure (capex): Future D&A and
Capex are forecasted on base of % revenue technique only. Past years D&A and Capex
are determined from the cash flow statement and % revenue is calculated for last few
years. Based on this trend future % revenue is determined on basis of trend analysis. Then
these % revenues are used to calculate D&A and Capex for future years. Just keep in mind
Capex should not be less than D&A, if it is the case please confirm of Balance Sheet that
Net Plant, Property and Equipment line item is decreasing i.e. assets of company are
decreasing. Then in that case take Capex equal to D&A for future years’ projection.
iv. Tax Rate: Past years’ tax rate should be calculated and is to be used for cash flows
determination. In case company is not paying any taxes then in that case corporate tax
rate of Target’s country should be used. If company is getting some subsidy in taxes
because of some government schemes, please determine these subsidies from Annual
report and use them for calculating effective tax rate.
 v. Working Capital: There are two main methodologies which are used to forecast working
capital: % revenue methodology and Cash conversion cycle methodology.
o % Revenue Methodology: Working capital is calculated Total Current Assets
excluding Cash minus Total Current liabilities excluding short term debt. For past
years working capital as % of revenue is calculated and future % revenue is
forecasted on basis of trend analysis.
o Cash Conversion Cycle methodology: It has three components Inventory Days
outstanding, Receivable Days outstanding and Payable Days Outstanding.
Inventory days outstanding (DIO): DIO are calculated for past years and
forecasted for future as per trend analysis.

DIO: Average Inventory ((Beginning inventory + End Inventory)/2) / Cost of Goods

Sold *365 days

Then Inventory is calculated for future years by using the above formula in
reverse order.

Receivable days outstanding (DSO): DSO are calculated for past years and
forecasted for future as per trend analysis.

DSO: Average Receivables ((Beginning receivables + End receivables)/2) /

Revenue*365 days

Then receivables are calculated for future years by using the above formula in
reverse order.

Payable days outstanding (DPO): DPO are calculated for past years and
forecasted for future as per trend analysis.

DSO: Average Payables ((Beginning payables + End payables)/2) / COGS*365 days

Then payables are calculated for future years by using the above formula in
reverse order.

Finally Working capital is calculated: Inventory + Receivables – Payables

b) Calculating Weighted average cost of capital (WACC): This is calculated for the company which
is acquiring other company. All the below data used should be used of the acquiring company
except Tax rate (it will be the effective tax rate of acquired company). It includes two
components: Cost of debt (Kd) and Cost of equity (Ke).

WACC = (Debt/Capital) * Kd + (Equity/Capital) * Ke

Where: Capital: Debt + Equity

Now there are multiple approaches for calculating Kd and Ke. Please find below the details for
calculating Kd and Ke.
i. Cost of Debt (Kd): It takes care of debt funding part of capital.

Kd = Market rate of company’s debt * (1-tax rate)

Where Market rate of company’s debt is calculated by one of the following

methodologies:

o Latest rate at which company has taken debt: It is the rate at which company has
taken latest debt from market. This can be get from Annual report.
o Average interest rate of peers: It is the interest rate which the peers of acquiring
company are incurring on their debt.

ii. Cost of Equity (Ke): It takes care of Equity funding part of capital.

Ke = Risk Free Rate of Target’s Country (RFR) + Beta *(Market Return – RFR)

Where different above mentioned components are calculated as following:

o RFR: It is the 10-year government bond rate of target’s country.

o Beta: It is the measure of volatility of the asset. If target company is listed then the
Beta of the stock from directly from stock exchange can be used or alternatively the
following formula can also be used:

Beta: Covariance (Ri,Rm) / Variance (Rm)

Where:
Ri: Daily Return on target’s stock for last five years
Rm: Daily Return on target country’s stock market benchmark index for last five
years
Then calculate the covariance and variance for this dataset using excel formulas
COVARIANCE.P and VARIANCE.P.

But, if target is not listed then the Beta is calculated by Levered Beta method.

For the listed peer set of target company, market data is collected and unlevered
Beta for all the individual peers is calculated as per following formula.

Unlevered Beta: Beta from Stock Exchange / ((1 + (1-tax rate) *(Debt/Equity)

Then to calculate Beta of target the average of all the unlevered betas is taken and
then levered for Target D/E and tax rate.

Target Beta: Average Unlevered Beta * ((1 + (1-tax rate) *(Debt/Equity)

Also, for including the illiquidity risk and non-divergence risk in this beta we need to
include a factor for illiquidity. As per renowned professor Damodaran, it is calculated
as following:
 Total Target Beta: Target Beta / Average correlation coefficient of public traded
peers with market

o Market Return (Rm): It is the average historical market return of target company’s
stock index.

Now, you must be wondering that Rm from above method will be have an inherent
risk for the countries which don’t have developed share markets. In that case, there
is an alternative approach as suggested by Professor Aswath Damodaran. He
suggests taking the market return of some stable and developed country like US and
then adding country risk premium over it. For this approach, he directly provides
table with Equity risk premiums (Rm – RFR) for every country.
Please use the link below for the data on Equity risk premiums:

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

c) Terminal growth rate (g): As we are forecasting the financials for a limited period in future, so
the rest of the value that lies in the company is also need to be captured. For this purpose,
terminal growth rate needs to be ascertained. Typically, it ranges in between 1%-4% based on
country’s historical inflation rate and historical growth rate. One point that should be kept in
mind, ‘g’ can’t be higher than WACC.

d) Calculating Future cash flows (FCF): We have already forecasted all the data which we will
require calculating the FCF. FCF here concerned is also known by name of Free Cash Flow to
Firm. Formula for calculating FCF is as following:

FCF1= EBIT1 *(1-tax rate) + D&A1 – Capex1 – Change in Working Capital (WC1 – WC0)

For ex: FCF2018 = EBIT2018 * (1-tax rate) + D&A2018 – Capex2018 – (WC2018 – WC2017)

Above formula should be used to calculate all the future cash flows for forecasted years.

e) Calculating Present Value (PV) of Future Cash flows: FCF calculated above are all value in future
years and need to be discounted at WACC to get their Present Value. Formula for calculating
Present Value is as following:

PVi = FCFi / ((1+WACC) ^i)

For ex: PV2018 = FCF2018 / ((1+WACC) ^2) as FY18 is second forecasted year assuming calendar year

Above formula should be used to calculate PV for all the future cash flows for forecasted years.

f) Calculating Terminal Value (TV): Going concern basis assumption behind any company’s working
leads us to calculate Terminal Value, as we have forecasted for a considerably brief period
against assumption of perpetuity. Formula for calculating Terminal Value is as following:

TV= FCF last Year * (1+g) / ((WACC – g) * ((1+WACC) ^forecasted years))

 For ex: TV = FCF2021 * (1+g) / ((WACC – g) * ((1+WACC) ^5)) as FY21 is fifth and last forecasted year
assuming calendar year.

g) Enterprise Value (EV): Finally, EV can be calculated using the DCF, as all the components are
calculated above.

EV = Sum of PVs + TV

I have captured the methodology in an excel template. Please download the file from below link:
https://drive.google.com/file/d/0B8GwA2wLuBigTTR1YmRNT1FpbDg/view?usp=sharing

For understanding about Relative Valuation Methodology, please see the below link: