The DCF method explained

 

The Discounted Cash Flow (DCF) method is one of the most commonly used methods for valuing companies and shares. The DCF method is based on the fact that the value of a company can be determined by calculating the present value of all future cash flows that can be expected. This method is the most commonly used valuation method in the business community because of it is the only method that explicitely includes all relevant factors. In addition to future expected cash flow, risks and the time value of money are taken into account. High risk cash flows have less value then low risk cash flows, and cash flows that are received further in the future have lower value than cash flows that are received sooner.

The Discounted Cash Flow method is used in practice by analysts, investors and financial professionals to support various investment decisions. This method also allows to perform sensitivity analyses and see the (level) of change in the value when certain assumptions (e.g. growth expectations, margins, investment levels) are changed.

How does the DCF method work?

To apply the Discounted Cash Flow method, it is first important to estimate the future cash flows of the company or project. This data can be obtained by making a forecast of the expected revenues and expenditure (both costs and investments) for the coming years. When drawing up the forecast, historical data, market research and industry trends can be used.

Once the above data is obtained, the future cash flows that are the result of these assumptions, are discounted to the present value using the discount rate. The discount rate is based on the company's cost of capital, which is the (minimal) return that capital providers require on providing equity or debt.

By discounting future cash flows to the valuation date, the risk of the cash flows and the time value of money are taken into account. In practice, this means that future cash flows are worth less than the same cash flows received now. A euro you receive today is worth more than an (uncertain) euro you expect to receive next year.

By using the above method, an estimate of the value of a company can be made. The value of the shares can be determined by adding the value of participating interests, investments and liquid assets to that enterprise value, and then subtracting the value of the debt.

Advantages of the DCF method

The DCF method has several advantages in determining the value of a company or project, namely:

• Complete: The DCF method is known to be the only methods that includes all relevant aspect needed for determining the value of a company. Because the time value of money and the risk associated with the expected cash flows is taken into account, a proper estimate can be made of the value of a company or business.
  
  
• Investment decision support: The method helps investors make various investment decisions. This means that the investor knows where he/she stands what the value contribution will be of the proposed investment.
  
  
• Flexibility: The DCF method is a flexible method that can be adapted to different companies and businesses.                              
• Mapping business performance: The DCF method can also be used to map business performance. By gaining insight into the cash flows, the strengths and weaknesses within the company can be examined. Based on this, possible improvements can be identified.
  
  
• Strategic planning: Finally, the DCF method can also be used to promote strategic planning. Future cash flows can be analyzed, allowing decisions to be made about future investments.
  
  

Disadvantages of the DCF method

There are also some disadvantages to using the DCF method, namely:

• Dependency: When using the DCF method, assumptions will be made about future cash flows and other factors such as the cost of capital. If these assumptions are not realistic, the estimates may differ from the actual situation.
  
  
• Time-consuming: Although drawing up the analysis pays off in terms of results, executing the method can be a time-consuming job. Especially when a financial model has to be contructed by the valuer. In addition, various financial data is needed to implement the method. This can make it more difficult for some companies to implement this method properly.