WHAT IS A DISCOUNTED CASH FLOW MODEL?
What is a Discounted Cash Flow Model?
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.
|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
Disadvantages of using DCF method
- 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.
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The information provided is for general information purposes only and is not intended to be any investment or financial advice. All views and opinions articulated in the article were expressed in Willie’s personal capacity and do not in any way represent those of his employer and other related entities. Willie doesn’t own shares in any companies mentioned above.
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