What is a Discounted Cash Flow Model?

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A Discounted Cash Flow (DCF) model is a valuation method used to estimate what a business might be worth today, say N years from now. It determines the present value of future cash flows a firm could potentially generate from its underlying operating assets. An assumption of a base value (i.e. cash flow), growth rate and discount rate (opportunity cost) is required to estimate a firm’s value as shown in the formula below.

Historical values can be used to determine the reasonableness of estimates in the DCF model. One example could be studying the trends in International Business Machine’s (NYSE:IBM) free cash flow shown in the table below. By considering what might continue to drive the IT solutions company’s growth prospects, its cash flow sustainability and the inherent risks the business might face, an investor can roughly project the input variables for the DCF model.

 Year 2009 2010 2011 2012 2013 Operating cash flow (USD millions) 20,773 19,549 19,846 19,586 17,485 Capital expenditure (USD millions) -4,108 -4,185 -3,447 -4,082 -3,623 Free cash flow (USD millions) 16,665 15,364 16,399 15,504 13,862

Source: company reports

Advantages of using the DCF method

• It is a quick and easy way to calculate the value of a company
• It can used to supplement  other  more complex valuation methods
• It can be used to determine the price-implied growth rates and discount rate

• Difficult to estimate Input variables (i.e. growth rate, discount rate, length of projection)
• Small changes in variables could lead to large swings in the calculated value

Value in Action

A DCF model is one of the several valuation tools in determining what might be a reasonable price an investor would pay for a portion of the company’s future earnings. Although it is a quick and easy way to calculate the inputs, it is critical to consider whether the estimates are reasonable and what are the key drivers for the projections used.