Modeling Discounted Cash Flows

Discounted Cash Flow (DCF) analysis is the bedrock of modern-day financial analysis. It is for this reason that financial modelers use discounted cash flow analysis extensively. In fact, the DCF analysis may have been the reason why the field of financial modeling came into existence in the first place.

In this article, we will have a closer look at how the techniques of financial modeling need to be used in order to create a discounted cash flow model.

Knowing When to Use DCF Modeling

Creating a discounted cash flow model is an extremely complex and time-consuming task. This is because a DCF analysis usually takes inputs from all three financial statements. The EBIDTA is taken from the income statement. Capital expenditures and other long term expenses are taken from the balance sheet. Cash outflows like interest rates are taken from the cash flow statement.

Hence, it would be fair to say that the discounted cash flow analysis uses a complex mechanism where inputs from all financial statements are used in order to create an output. Since this is a complex mechanism, investment bankers generally use readymade templates for an approximation. A detailed discounted cash flow model, is only created when an important decision, such as a merger or a spinoff, is being considered.

The procedure to create a financial model for discounted cash flow analysis has been mentioned below.

Two-Step Process

The value of any company can be found out using discounted cash flow analysis. There are two steps which need to be performed. They are as follows:

1. Firstly, the number of years need to be decided for which accurate cash flow forecasts will be created. Then, assumptions like the growth rate and discount rate should also be clearly mentioned. For instance, if the financial modeler decides that forecasts will be created for a period of seven years, then they need to prepare detailed forecasts for that period. This is the first part of the process where the firm is considered to be an operating concern for a certain period of time. The valuation derived using this process can be considered to be the first part of the company’s total valuation.

2. Secondly, the firm is considered to be a going concern. This means that it is assumed that the firm will continue to provide cash flows till perpetuity. As a result, the terminal value of the firm is obtained using this formula. This terminal value is considered to be the second part of the company’s total valuation.

The total value of the firm is derived by adding the first and second part of the valuation. From a financial modeler’s point of view, this means that they have to develop two separate models. The results of both these models need to be added in the end to derive the final value using discounted cash flow analysis.

However, both the steps of the process are very sensitive to assumptions. This means that a slight change in the assumption can create a huge change in the final valuation. It is therefore important for the financial modeler to ensure that the assumptions are the same

Value During the Horizon Period:

The value of the operating concern can be calculated in one of the two ways.

In the first way, only the operating income of the firm is considered. This means that the effect of financing and investing is not considered at first. During a later stage, the non-operating assets and the possible income that they will generate are added to the operating value. The advantage here is that the effect of financing and investing is separated from the operations. This gives the financial modeler and the users of the model a clearer picture of the profits which can be expected to continue during the later years.

There is a second way, where the modeler directly begins the calculation with net profit after taxes. This method makes the financial modeling easy. However, it is limited with respect to the breakup of the information that it provides.

In most cases, the financial modeler would be better off using the first approach. This is because they can easily demonstrate the effect that a change in the interest rate or any other financing arrangement will have on the value of the firm during the horizon years.

Terminal Value:

The second part of the DCF valuation includes calculating the terminal value. This can also be done in two ways. From a calculation point of view, both the ways are quite easy. However, the result that they may provide is likely to be very different. Since terminal value accounts for over 50% of the value of the firm, the method followed here makes quite a difference.

From a calculation point of view, both the methods are easy. One of the methods involves considering the firm to be growing perpetuity. The other method involves the usage of an EBIDTA multiple. The multiplier factor can be derived by doing an analysis of the other firms in the industry.

In conclusion, the discounted cash flow analysis is an elaborate and complex financial modeling technique. It should only be used when the fruits from the effort justify the huge effort which is required in this case. Also, the methods must be carefully chosen to avoid over or undervaluation of the firm.