6.3 Discounted Cash Flow (DCF) Valuation Techniques

Discounted Cash Flow (DCF) valuation is a key tool in finance for estimating an investment's worth. It involves forecasting future cash flows and discounting them to present value, considering the time value of money and risk.

DCF analysis is crucial for making informed investment decisions. By understanding concepts like Net Present Value (NPV), Internal Rate of Return (IRR), and Weighted Average Cost of Capital (WACC), you can better assess the potential value and risks of various financial opportunities.

DCF Valuation Basics

Discounted Cash Flow (DCF) Valuation

• DCF is a valuation method used to estimate the intrinsic value of an investment based on its expected future cash flows
• Involves forecasting future free cash flows (FCF) and discounting them back to the present value using a discount rate that reflects the riskiness of those cash flows
• The discount rate is typically the weighted average cost of capital (WACC) which represents the cost of financing for the company
• The sum of all the discounted future cash flows is the net present value (NPV) which represents the intrinsic value of the investment

Net Present Value (NPV) and Internal Rate of Return (IRR)

• NPV is the difference between the present value of cash inflows and the present value of cash outflows over a period of time
• A positive NPV indicates that the projected earnings generated by a project or investment exceed the anticipated costs ($NPV > 0$)
• IRR is the discount rate that makes the NPV of all cash flows equal to zero in a discounted cash flow analysis
• IRR is used to evaluate the attractiveness of a project or investment ($IRR > WACC$ is desirable)
• Both NPV and IRR are used in capital budgeting to analyze the profitability of projected investments or projects

Free Cash Flow and Terminal Value

• Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets
• FCF is calculated as: $FCF = [Operating Cash Flow](https://www.fiveableKeyTerm:Operating_Cash_Flow) - [Capital Expenditures](https://www.fiveableKeyTerm:Capital_Expenditures)$
• FCF is used in DCF analysis to determine a company's value or the value of a specific project
• Terminal value (TV) is the value of a project or investment beyond the explicit forecast period in a DCF analysis
• TV assumes that the company will continue to generate cash flows at a stable growth rate forever after the explicit forecast period
• TV is calculated using the perpetuity growth method: $TV = \frac{FCF_{n} \times (1 + g)}{(r - g)}$ where $FCF_{n}$ is the free cash flow in the last year of the explicit forecast period, $g$ is the stable growth rate, and $r$ is the discount rate (typically WACC)

Cost of Capital

Weighted Average Cost of Capital (WACC)

• WACC represents the average cost of financing for a company, considering both debt and equity
• WACC is used as the discount rate in DCF analysis to determine the present value of future cash flows
• WACC is calculated as: $WACC = (E/V \times R_e) + (D/V \times R_d \times (1 - T_c))$ where $E$ is the market value of equity, $D$ is the market value of debt, $V$ is the total market value of the company $(E + D)$, $R_e$ is the cost of equity, $R_d$ is the cost of debt, and $T_c$ is the corporate tax rate
• The cost of equity ($R_e$) is typically estimated using the Capital Asset Pricing Model (CAPM): $R_e = R_f + \beta \times (R_m - R_f)$ where $R_f$ is the risk-free rate, $\beta$ is the company's beta (a measure of systematic risk), and $R_m$ is the expected return of the market

Unlevered and Levered Free Cash Flow

• Unlevered free cash flow (UFCF) is the cash flow available to all investors (equity and debt) before considering the impact of debt financing
• UFCF is calculated by adding back the tax-adjusted interest expense to the free cash flow: $UFCF = FCF + Interest Expense \times (1 - T_c)$
• Levered free cash flow (LFCF) is the cash flow available to equity investors after considering the impact of debt financing
• LFCF is calculated by subtracting the interest expense and principal repayments from the free cash flow: $LFCF = FCF - Interest Expense \times (1 - T_c) - Principal Repayments$
• In DCF analysis, UFCF is discounted at the unlevered cost of capital (typically the cost of equity) while LFCF is discounted at the levered cost of capital (WACC)

Growth and Sensitivity

Growth Rate and Sensitivity Analysis

• The growth rate is a critical assumption in DCF analysis as it determines the expected future cash flows of the company or project
• In the explicit forecast period, the growth rate can be estimated based on historical performance, industry trends, and company-specific factors
• In the terminal value calculation, a stable growth rate is assumed which should be lower than the expected long-term economic growth rate
• Sensitivity analysis is a technique used to determine how different values of an independent variable (e.g., growth rate, discount rate) affect a particular dependent variable (e.g., NPV, intrinsic value) under a given set of assumptions
• Sensitivity analysis helps to identify the key drivers of value in a DCF model and assess the impact of changes in assumptions on the valuation

Scenario Analysis

• Scenario analysis is a process of analyzing possible future events by considering alternative possible outcomes (scenarios)
• In the context of DCF analysis, scenario analysis involves creating multiple sets of assumptions (e.g., base case, best case, worst case) and calculating the intrinsic value under each scenario
• Scenario analysis helps to assess the range of possible outcomes and identify the key risks and opportunities associated with an investment or project
• By assigning probabilities to each scenario, an expected value can be calculated as the probability-weighted average of the intrinsic values under each scenario
• Scenario analysis provides a more comprehensive view of the potential outcomes and helps investors and managers make more informed decisions based on a range of possibilities rather than a single point estimate