- Calculates present value by discounting future free cash flows (FCF) at an appropriate discount rate (WACC or required return).
- Common in business valuation, project finance, and investment analysis.
Step-by-Step Procedures for Performing Discounted Cash Flow (DCF) Valuation
Step 1: Define the Scope and Purpose of the Valuation
- Determine the objective: business valuation, investment analysis, Greenfield project feasibility, M&A, or financial reporting.
- Define the valuation date.
- Identify the cash flow entity: equity valuation (free cash flow to equity, FCFE) or enterprise valuation (free cash flow to the firm, FCFF).
Step 2: Forecast Free Cash Flows (FCF)
A. Choose the Type of Cash Flow
- Free Cash Flow to the Firm (FCFF) – Used for enterprise valuation.
- Formula: FCFF=EBIT(1−Tax Rate)+Depreciation−Capital Expenditures−Changes in Working CapitalFCFF = EBIT(1 - \text{Tax Rate}) + \text{Depreciation} - \text{Capital Expenditures} - \text{Changes in Working Capital}FCFF=EBIT(1−Tax Rate)+Depreciation−Capital Expenditures−Changes in Working Capital
- Free Cash Flow to Equity (FCFE) – Used for equity valuation.
- Formula: FCFE=NetIncome+Depreciation−Capital Expenditures−Changes in Working Capital+Net BorrowingFCFE = Net Income + \text{Depreciation} - \text{Capital Expenditures} - \text{Changes in Working Capital} + \text{Net Borrowing}FCFE=NetIncome+Depreciation−Capital Expenditures−Changes in Working Capital+Net Borrowing
B. Develop Financial Projections
- Forecast revenue growth based on historical performance, industry trends, and economic conditions.
- Estimate operating expenses and EBIT (Earnings Before Interest & Taxes).
- Adjust for working capital requirements.
- Estimate capital expenditures (CapEx) required for future growth.
- Forecast FCF for at least 5-10 years.