Discounted Cash Flow (DCF)

What is Discounted Cash Flow (DCF)?

A Discounted Cash Flow or DCF is one of the most important methods used to value a company. A DCF is carried out by estimating the total value of all future cash flows (both inflowing and outflowing), and then discounting them (usually using Weighted Average Cost of Capital – WACC) to find a present value of that cash. The aim of a discounted cash flow is to estimate the total amount of cash you will receive from an investment, and if this value is higher than the cost of the investment, it is usually worth doing. The process behind creating a DCF model is as follows:

  • Project Future Cash Flows - this is usually done from a 3-statement projection model or by using simple assumptions about Revenue, Tax, Depreciation, Amortization etc and calculating free cash flow from there
  • Calculate the Discount Rate - this is either taken to be a simple percentage or is calculated using WACC
  • Discount Future Cash Flows - either by using the Mid-Year discount or a simple discount period, it is fairly simple to calculate the present value of future cash flows
  • Estimate Terminal Value - Terminal Value is then estimated either by using a terminal exit multiple (usually an EBITDA multiple) or with a Terminal Growth Rate (Gordon Growth Method)
  • Find the Net Present Value - to find the net present value simply discount the terminal value (again using WACC or a simple %) and then add that to the sum of the discounted cash flow values
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