Discounted cash flow (DCF)
Valuing a company by discounting its future cash flows.
What a company is worth: its future cash flows
The DCF method values a company by discounting the cash flows it will generate. A euro in ten years is worth less than a euro today: it is divided by (1 + rate)^10, the rate being the weighted average cost of capital. Beyond the forecast horizon, a terminal value sums up all later flows.
Very sensitive to assumptions
One point more or less on the discount rate or perpetual growth can move the value by 20 to 40%. A DCF is less about finding an exact price than understanding which assumptions today’s price implies.
Formula
Valeur = Σ FCF(t) / (1 + CMPC)^t + VT / (1 + CMPC)^N ; VT = FCF(N+1) / (CMPC - g)
- FCF: free cash flow
- WACC: weighted average cost of capital
- g: perpetual growth
Worked example
A terminal value
- Cash flow next year: 102 million, growing 2% a year forever.
- Cost of capital: 8%.
- Value: 102 / (0.08 - 0.02) = 1,700 million. With a 7% cost of capital: 102 / 0.05 = 2,040 million.
One point less on the rate adds 20% of value.
Common mistakes
- Assuming perpetual growth above that of the economy.
- Letting the terminal value make up 80% of the total without noticing.
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