The Discounted Cash Flow ("DCF") method is part of the Income approach family of valuation methodologies, which convert future benefits to a monetary present value. Under the DCF, the expected future cash flows of a business and/or its underlying assets are discounted back to the valuation date to calculate the present value ("PV") of the business over the discrete period. In valuing a going concern (i.e. a business expected to operate in perpetuity), a terminal value ("TV") is estimated at the end of the forecast period and discounted back to the valuation date to calculate the PV of the business over the terminal (or residual) period. The overall valuation for the business is given by the sum of the PV of the discrete and terminal periods.
The rate at which the forecasted cash flows are discounted, i.e. the discount rate, should reflect:
the time value of the cash flows, and
the risks associated with the operations of the business.
Click here to jump to our article on how to estimate the discount rate.
In this article, we specifically look at how to structure a DCF to estimate the Enterprise Value ("EV") of a business, based on forecasted Free Cash Flows to the Firm ("FCFF") discounted at a WACC.
When to use the DCF method
The DCF method should be considered to perform the asset-side valuation (i.e. estimate the Enterprise Value) of non-financial corporations and businesses. For financial institutions, the DCF method is applied to directly estimate their Equity value, based on forecasted Free Cash Flows to Equity or dividends (in the latter case more appropriately called the Dividend Discount Model, or "DDM") discounted at a cost of equity: we shall address equity-side valuations in a separate article.
The DCF is the primary valuation method to use when financial projections are made available by the management of the company or project that you are valuing. As a consultant, you would typically request (and expect/hope to receive in a formula-linked Excel file) a detailed forecast of the income statement, the balance sheet and (for non-financial institutions) the cashflow statement for the business you are valuing, covering a period of 5 years.
The first year of projections is generally based on a recently updated budget. Sometimes, depending of the client, the budget is the only forecast available: in this case, you would not be able to apply the DCF, but may instead consider the Capitalized Earnings method (which we will address in a separate article).
Unless you have been engaged to work on a business planning exercise, the preparation of financial projections falls outside of your scope of work. Also, an advisor cannot (and will not) assume responsibility over the forecasts prepared by the client's management, including the key underlying assumptions. Nevertheless, even if out of scope, it is not uncommon for an advisor to assist their client in constructing the forecasts, or modifying their original version: in the end, it is also in your best interest to use forecasts that are properly constructed and, more importantly, not overly optimistic (not to say unrealistic).
If all attempts fail at convincing your client that their projections are, in fact, worthy of a sci-fi novel, you would typically create one or more alternative scenarios by sensitizing management's forecasts to reflect growth rates that are more in line with the market consensus. You will then arrive at your valuation result based on these alternative scenarios.
Case 1. Use the DCF to value a start up, for 2 main reasons: 1. The company's LTM EBITDA will most likely be negative, making the use of revenue multiples the only viable option to value the business using an earnings metric under the Market approach. 2. More importantly, you would expect to see significant growth in the first 3-5 years of operations, and the DCF would allow you to capture the expected intrinsic value of the business. This is something that is neither reflected in today's financial performance, nor that would be captured by other valuation methods. It is common that the management would expect the start up to become EBITDA- and cash flow-positive towards the end of the forecast period: a start up's valuation would, therefore, be made up almost entirely of the terminal value.
Case 2. Use the DCF to value a company that is currently undergoing a business turnaround, reorganization or restructuring, for 2 main reasons: 1. The company's LTM EBITDA will most likely be negative, making the use of revenue multiples the only viable option to value the business using an earnings metric under the Market approach. However, unlike for start ups, revenue multiples are generally not accepted to value more mature firms. If the company has a positive equity as at the valuation date, book value multiples may also be considered (e.g. P/BV), but these are generally considered acceptable when valuing financial institutions only. 2. More importantly, you would generally expect to see a return to profitability at EBITDA level and a positive cash flow generation towards the second half or end of the projection period (i.e. years 3-5). The DCF would allow you to capture the results and benefits expected from the restructuring plan put in place by the management. This is something that is neither reflected in today's financial performance, nor that would be captured by other valuation methods.
Free Cash Flows
The DCF is based on free cash flows, not earnings. They are called "free", meaning they are available for distribution to all of the business's capital providers (both debt and equity). FCFF are calculated as follows:
FCFF = EBIT - Tax + Depreciation & Amortization - Changes in Net Working Capital - Capex
Tax is calculated by applying to your forecast EBIT the relevant corporate tax rate, i.e. that of the country in which the business generates revenue as at the valuation date. If the company operates in more than one country, and you are valuing the business on a consolidated level, calculate the blended tax rate based on each country's contribution expressed in terms of your preferred earnings or cash flow metric.
Depreciation and amortization are non-cash expenses, which are added back to the forecast EBIT for the FCFF calculation: as they merely constitute accounting adjustments, they have no impact in terms of cash (no cash burn).
Net Working Capital ("NWC") is calculated as the difference between current assets and current liabilities. The items that compose the NWC are core to the operations of the business (commercial, not financing in nature):
NWC = Trade and other receivables + Inventory + Other non-financial current assets - Trade and other payables
Other receivables may include, among others:
advances to suppliers.
Other payables may include, among others:
advances from customers.
Excluded from NWC are non-operational items, such as cash and bank balances, financial assets and financial liabilities.
In case of a joint engagement between the due diligence and the valuation teams, the latter will generally rely on the former's findings with regards to the composition of NWC. The due diligence team, in their analysis of the company's financials, may deem necessary to adjust certain WC items that, after a closer inspection, are not operational in nature (resemble financing) or are to be written-off. These may include stretched payables, overdue/write-off receivables and obsolete inventory, among others.
The cash impact of the balance sheet items that constitute the NWC is linked to their variation: an increase in assets results in a cash outflow, while an increase in liabilities results in a cash inflow (and viceversa). Therefore, in our FCFF calculation we must subtract the changes in NWC: we subtract an increase in NWC, which may result from higher assets and/or lower liabilities (cash outflow); we add a decrease in NWC, which may in turn result from lower assets and/or higher liabilities (cash inflow).
Lastly, we subtract the capital expenditures that the management plans to incur across the projection period. The client should be able to send you detailed information about the major capex projects underlying the projections (high-level description of the investments, timing, costs, etc.). At times, the management may solely expect to incur maintenance capex across the projection period, meaning that they neither plan to expand the business's production capacity, nor do they foresee the need to replace existing fixed assets. In any case, it is good practice to carry out an analysis on the historical capex levels compared to revenues, in order to assess whether an appropriate level of capex is considered across the projection period.
The TV can be estimated in either of the following ways:
1. Capitalization of TV FCFF based on the Gordon Growth Model (most popular)
Start by estimating the terminal period EBITDA by increasing the EBITDA of the last projection year by your long-term growth rate (g). If 2025 is the final year of projections, TV EBITDA is calculated as follows:
TV EBITDA = 2025 EBITDA x (1 + g)
Terminal period depreciation & amortization are generally considered equal to terminal period capex, the assumption being that depreciation and investment will balance out in perpetuity and the business's asset base will remain stable. TV capex may be estimated as follows:
increase the final year capex by your g (as done for terminal period EBITDA);
in case the client's management has solely forecasted maintenance capex across the projection period, make sure that TV capex also include the so-called refresh capex, i.e. the replacement cost of plant, property and equipment estimated based on their useful life (as per the financial statements) and historical cost (as per the fixed assets register) increased to consider inflation (equal to your g).
Subtract TV depreciation & amortization from TV EBITDA to arrive at TV EBIT, on which you will calculate the terminal period tax. Apply the same corporate tax rate considered for the projection period.
To estimate the terminal period changes in NWC, you may choose one of the below options:
calculate the NWC/Revenue ratio of the final projection year or an average across the projection period, apply it to TV revenue to estimate the terminal period NWC, and calculate the difference between TV NWC and the NWC of the final projection year;
calculate the changes in NWC/Revenue ratio of the last projection year or the projection period average, and apply it to TV revenue;
estimate the single NWC items in the terminal period based on the average turnover days applied to the relevant metric (i.e. to TV revenue for trade receivables, and to TV cost of goods sold for inventory and trade payables), then subtract TV NWC by the NWC of the final forecast year.
Once you have arrived at the TV FCFF, capitalize the cash flows using the Gordon Growth formula, as illustrated below:
Undiscounted TV = TV FCFF / (WACC - g)
2. Exit multiple
Alternatively to the Gordon Growth Model, you may estimate the undiscounted TV by applying an exit multiple to the relevant earnings metric of the last year of projections, e.g. EV/EBITDA exit multiple applied to final year EBITDA, or EV/Revenue exit multiple applied to final year revenue. The exit multiple will be based on an analysis of the trading and transaction multiples as at the valuation date. This method generally yields a higher TV compared to that estimated using the Gordon Growth formula.
The EV of the business is equal to the PV of the FCFF expected across the projection period and (if applicable) the terminal period. The PV is estimated by discounting the FCFF to the present (i.e. to the valuation date) at your WACC.
You may choose one of two kinds of period discounting:
the mid-year discounting, which assumes that the FCFF occur at the middle of each period, or
the end-of-year discounting, which assumes that the FCFF occur at the end of each period. Although more conservative compared to mid-year discounting, as it yields a lower valuation (ceteris paribus), it may also undervalue a business that generates cash flows at the beginning or throughout the whole period.
100% Equity value
The value of a 100% equity stake in the business is calculated as shown below:
100% Equity value = EV + Net cash/(debt) + Surplus assets/(liabilities)
Net cash/(debt) is equal to cash and bank balances (excluding any restricted cash), less financial liabilities. Financial liabilities may include, among others:
provision for end of service benefits, and
shareholder loans (if interest-bearing, with a defined repayment plan and maturity date).
Any surplus assets/(liabilities) held by the business are also assumed to be converted to cash and distributed at the beginning of the discounting period. These may include, among others:
plots of land or real estate assets that are not core to business operations (e.g held for sale),
deferred tax assets/(liabilities), and
investments in joint ventures.
Pro-rata equity value
If you are valuing an equity stake different from 100%, simply apply the specific % equity stake you are valuing to the 100% equity value estimated as above.
NB: this is based on the assumption that the FCFF considered in your DCF are majority cash flows (i.e. not already pro-rated, but related to a 100% equity stake).
Furthermore, you must assess whether it is appropriate to adjust your pro-rata equity value estimate by a minority discount, in order to reflect the embedded lack of control implied by a minority stake: a minority shareholder, in fact, may not be able to single-handedly and actively influence the strategic decision making of the business through its Board representation (if any). As per best market practices, the minority discount typically ranges from 5% (for a significant minority stake with Board representation) up to 40%.
We hope you found this article useful. Make sure to download our DCF model template in Excel:
In the Input tab you can update/select the key assumptions, including valuation date, discount rate, g and period discounting type. This tab also includes checks on the sensitivity tables.
Our template includes:
the DCF model to value majority stakes of going concerns, the TV based on the Gordon Growth Model,
the DCF model to value minority stakes of going concerns, the TV based on the Gordon Growth Model, and including an adjustment to equity value for the minority discount,
the DCF model to value majority stakes of going concerns, the TV based on an exit EV/EBITDA multiple, and
the DCF model to value majority stakes of going concerns, the TV based on an exit EV/revenue multiple.
Lastly, all DCF models include:
a sensitivity analysis on the discount rate and g (for DCFs 1 and 2), and on the discount rate and the relevant exit multiple (for DCFs 3 and 4),
the calculation of implied multiples, and
the workings for the estimation of TV changes in net working capital.
For questions or clarifications, feel free to reach out. Thanks for reading, and good luck!