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6. Discounted Cashflow Valuation (DCF)
DCF is a comprehensive valuation technique based on the idea that a business’s value is the present value of its projected future cash flows. These cash flows are ‘discounted’ back to today’s dollars using a discount rate, typically a company’s Weighted Average Cost of Capital (WACC). DCF provides a more forward-looking valuation but relies heavily on accurate estimations of future cash flows and appropriate discount rates.
The ‘Discounted Cashflow Valuation’ (DCF) method is based on the principle that the value of a business is the present value of its expected future cash flows. These future cash flows are “discounted” back to the present using an appropriate discount rate (often the company’s Weighted Average Cost of Capital, which includes the cost of equity). This method is one of the most detailed and commonly used valuation methods, especially for established companies with predictable cash flows.
The table below provides an explanation and an example for each of the input variables related to the ‘Discounted Cashflow Valuation’ method:
|Cost of Equity||This represents the return that equity investors expect to earn from their investment in the company. It’s used as the discount rate when discounting future cash flows in the DCF method, reflecting the opportunity cost of capital.||If market data and the Capital Asset Pricing Model (CAPM) suggest that investors expect a 10% return on their equity investments in the company, the cost of equity would be 10%.|
|Adjustments to Working Capital for Years 1,2,3,4,5||These adjustments reflect the changes in net working capital (current assets minus current liabilities) each year. These changes affect free cash flow as an increase in working capital represents a use of cash, while a decrease signifies a source of cash. Such adjustments are necessary to estimate accurate cash flows in the DCF method.||Let’s say a company expects to increase its inventory and accounts receivables in the upcoming years. The adjustments to working capital might be: +£20,000 (Year 1), +£15,000 (Year 2), +£10,000 (Year 3), +£5,000 (Year 4), and -£5,000 (Year 5).|