DISCOUNTED CASH FLOW (DCF) Valuation
Discounted Cash Flow (DCF) is one of the prominent Income approaches to valuation and is used to estimate the attractiveness of any Investment opportunity on the basis of future cash flow projections of business. So far DCF is considered as the most scientific financial tool to derive the value of any company based on parameters like Projected Cash Flows, Cost of Capital, Growth cycle of Business, perpetual growth rate etc. “The Discounted Cash Flow Method expresses the present value of the business attributable to its stakeholders as a function of its future cash earnings capacity. This methodology works on the premisethat the value of a business is measured in terms of future cash flow streams, discounted to the present time at an appropriate discount rate”.
This method uses the Free Cash Flows to equity (FCFE) and values the benefits that accrue to the equity shareholders of the Company. The value of the equity is arrived at by estimating the FCFE and discounting it at the cost of equity (Ke). This methodology is considered to be the most appropriate basis for determining the earning capability of a business. It expresses the value of a business as a function of expected future cash earnings in present value terms.
Key Issues and challenges in Discounted Cash Flow Methodology
• Cost of Equity Calculation
• Weighted Average Cost of Capital Calculation
• What should be the Terminal Growth Rate
However it is needed to be used with great care as it’s a very sensitive model where the values get affected significantly with a small change in assumption like Beta value, Terminal growth rate, Risk free rate of Return and market return. It is also recommended to do a sanity check with the Market Approach to valuation like CCM and Asset Approach i.e. Net Asset Value before concluding the value.