MSG Team's other articles

12336 The Anatomy of Commodity Indices

Movements in the stock markets are easy to track. This is because instead of looking at the movements in the price of several different stocks, investors can simply look at the movement in the underlying index. This is where the concept of index is derived from. It provides a pulse of the market wherein one […]

10032 Investment Banking and Special Purpose Acquisition Companies (SPACs)

Special Purpose Acquisition Companies (SPAC) have become all the rage in the investment banking industry. They are not a new concept. They have been around for quite some time. However, they have become quite popular in the recent past. For instance, in the first half of 2020, $13.5 billion dollars were raised by Special Purpose […]

10937 Relationship Banking in Commercial Banking

Commercial banking is fundamentally different from retail banking in several ways. One of the main differences between the two types of banking is the relationship management approach. The commercial banking system relies heavily on relationship management. Each and every corporate customer of a commercial bank has a dedicated relationship manager. This is possible because of […]

8764 Why are Pension Funds Important?

Individual investors are well aware of the existence of pension funds. Retail investors who earn their income in the form of a salary are likely to have invested in these funds. Other retail investors may also have invested in these funds. Almost everyone has heard about pension funds in the news. However, very few people […]

11450 The Sunk Cost Fallacy

In the previous article, we learned about how certain psychological factors make a huge impact on our decision-making about financial investment. We studied about what loss aversion is and how it impacts the decisions that we make. There is another psychological fallacy that is responsible for a lot of losses in the stock market. In […]

Search with tags

  • No tags available.

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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Creating a Revenue Model

MSG Team

What is Cost Modelling?

MSG Team

Circular References in Financial Modelling

MSG Team