The present value of future free cash flows to shareholders is the basis for which valuation method:

The Discounted Cash Flow (DCF) valuation model determines the company’s present value by adjusting future cash flows to the time value of money. This DCF analysis assesses the current fair value of assets or projects/companies by addressing inflation, risk, and cost of capital, analyzing the company’s future performance.
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Discounted Cash Flow (DCF) Valuation Analogy
7 Step of Discounted Cash Flow Valuation Model
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In other words, the DCF valuation model uses a company’s forecasted free cash flows and discounts them back to arrive at the present value estimate, which forms the basis for the potential investment now.

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Source: Discounted Cash Flow (DCF) (wallstreetmojo.com)

Discounted Cash Flow (DCF) Valuation Analogy

Let us take a simple discounted cash flow example. Suppose you can choose between receiving $100 today and obtaining $100 in a year. Which one will you take?

Here the chances are more that you will consider taking the money now because you can invest that $100 today and earn more than $100 in the next twelve months’ time. So, you thought about the money today because it is worth more than the money in the future due to its potential earning capacity (time value of money conceptThe Time Value of Money (TVM) principle states that money received in the present is of higher worth than money received in the future because money received now can be invested and used to generate cash flows to the enterprise in the future in the form of interest or from future investment appreciation and reinvestment.read more).

Now, apply the same calculation for all the cash you expect a company to be producing in the future and discount it to arrive at the net present value. You can have a good understanding of the company’s value.

Assuming that you understood this simple DCF stock example, we will move to the practical discounted cash flow example of Alibaba IPOAlibaba is the most profitable Chinese e-commerce company and its IPO is a big deal due to its size. With its huge size and network, Alibaba IPO may look at international expansion beyond China and may lead to price wars and intensive competition in the US.read more.

7 Step of Discounted Cash Flow Valuation Model

As a professional investment banker or an Equity Research AnalystAn equity research analyst is a qualified professional who interprets financial information and trends of an organization or industry to provide recommendations, opinions, reports, and projections on the corporate stocks to facilitate equity trading.read more. You are expected to perform DCF comprehensively. Below is a step-by-step approach to discounted cash flow analysis (as done by professionals).

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Here are the seven steps to Discounted Cash Flow (DCF) Analysis –

Step #1 – Projections of the Financial Statements

The first thing that needs your attention while applying discounted cash flow analysis is determining the forecasting period as firms, unlike human beings, have infinite lives. Therefore, analysts’ have to decide how far they should project their cash flow in the future. The analysts’ forecasting period depends on the company’s stages, such as early to business, high growth rate, stable growth rate, and perpetuity growth rate.

IMPORTANT – Do have a look at this step by step guide to Financial Modeling in Excel

The forecasting period plays a critical role because small firms grow faster than the more mature firms and thus carry a higher growth rate. So, the analysts do not expect the firms to have infinite lives because the small firms are more open to acquisition and bankruptcy than the larger ones. The thumb rule says that DCF analysis is widely used during a firm’s estimated excess return period in the future. In other words, for a company that stops covering its costs through investments or fails to generate profits, you need not perform DCF analysis for the next five years or so.

Forecasting is done professionally using Financial ModelingFinancial modeling refers to the use of excel-based models to reflect a company's projected financial performance. Such models represent the financial situation by taking into account risks and future assumptions, which are critical for making significant decisions in the future, such as raising capital or valuing a business, and interpreting their impact.read more. Here you prepare a three statement modelA 3 statement model is a type of financial modeling that connects three key financial statements: income statements, balance sheets, and cash flow statements. It prepares a dynamically linked single economic model used as the base of complex financial models like leverage buyout, discounted cash flow, merger models, and other financial models.read more and all the supporting schedules like the depreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more, working capital, intangibles, shareholder’s equityShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period.read more schedule, other long term items schedule, debt scheduleA debt schedule is the list of debts that the business owes, including term loans, debentures, cash credit, etc. Business organizations prepare this schedule to know the exact amount of the company's liability to others and manage its cash flows to prevent the financial crisis and enable better debt management.read more, etc.

Projecting the Income Statement

Thus, the top-line growth or revenue growth becomes the most important assumption in discounted cash flows that the analysts make about the company’s future cash flows.
Therefore, in forecasting top-line growth, we need to consider various aspects like the company’s historical revenue growth, the industry’s growth rate, and the development of the economy or GDP. Many analysts call it top to bottom growth rate, wherein they first look at the economy’s growth, then the industry, and finally, the company.
However, another approach called the internal growth rate formulaInternal Growth Rate is calculated by multiplying ROA of the company with the retention ratio of the company. The equation is as follows: IGR = ROA*r/(1-ROA*r).read more comprises return on equity and growth in retained earningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more. Thus, we will use a combined growth rate to forecast future revenue, including the top to bottom growth rate and internal growth rate.

Projecting the Balance Sheet

Projecting the Cash Flow Statements

Step #2 – Calculating Free Cash Flow to Firm

The second step in discounted cash flow analysis is to calculate the firm’s free cash flow.

Before we estimate future free cash flow, we must first understand what free cash flow is. Free cash flow is the cash left out after the company pays all operating and required capital expenditures. The company uses this free cash flow to enhance its growth by developing new products, establishing new facilities, paying dividends to its shareholders or initiating share buybacksShare buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet. This is done either to increase the value of the existing shares or to prevent various shareholders from controlling the company.read more.

Free cash flow reflects the firm’s ability to generate money out of its business, strengthening the financial flexibility that it can potentially use to pay its outstanding net debt and increase value for shareholders.

Calculate FCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.read more is as follows –

Free Cash Flow to Firm or FCFF Calculation = EBIT x (1-tax rate) + Non Cash Charges + Changes in Working capital – Capital Expenditure

After projecting the financials of Alibaba, you can link the individual items given below to find the free cash flow projections for Alibaba.

Having estimated the free cash flows for the next five years, we have to figure out the worth of these cash flows in the present time. However, to get to know the present value of these future cash flows, we would require a discount rate that one can use to determine the net present value or NPVNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more of these future cash flows.

Step 3- Calculating the Discount Rate

The third step in the discounted cash flow valuation analysis is to calculate the discount rate.

Several methods are being used to calculate the discount rate. But, the most appropriate way to determine the discount rate is to apply the concept of the weighted average cost of capital, known as WACC. First, however, you have to keep in mind that you have taken the right figures of equity and the after-tax cost of debtCost of debt is the expected rate of return for the debt holder and is usually calculated as the effective interest rate applicable to a firms liability. It is an integral part of the discounted valuation analysis which calculates the present value of a firm by discounting future cash flows by the expected rate of return to its equity and debt holders.read more, as the difference of just one or two percentage points in the cost of capital will make a vast difference in the fair valueThe fair value of an investment is the asset sale price that is agreeable to both the buyer and the seller. There is a caveat; the amount should be agreeable in a free trade scenario; there should be no external pressure or conditions.read more of the company. So, now, let us find out how the cost of equity and debt is determined.

Cost of Equity

Unlike the debt portion that pays a set interest rate, equity does not have an actual price that it pays to the investors. However, it does not mean that equity does not bear a cost. We know that the shareholders expect the company to deliver absolute returnsAbsolute return refers to the percentage of value appreciation or depreciation of an asset or fund over a certain period. Such assets include mutual funds, stocks and fixed deposits.read more on their investment in the company. Thus, from the firm’s viewpoint, the required rate of return from the investors is the cost of equity. If the company fails to deliver the necessary rate of return, the shareholders will sell their positions in the company. As a result, it will hurt the share price movement in the stock market.

The most common method to calculate the capital cost is apply the capital asset pricing modelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more or (CAPM). As per this method, the cost of equity would be (Re)= Rf + Beta (Rm-Rf).

Where;

Cost of Debt

The cost of debt is easy to calculate compared to equity. The rate implied to determine the cost of debt is the current market rate that the company pays on its current debt.

For simplicity in the context of the discussion, I have taken the WACC figures directly as 9%.

IMPORTANT – You can refer to our detailed + [Cost of Debt * % of Debt * (1-Tax Rate)]” url=”https://www.wallstreetmojo.com/weighted-average-cost-capital-wacc/”]WACC guide”The, wherein we have discussed how to calculate this professionally with multiple examples, including that of Starbucks WACC.

Step 4 – Calculating the Terminal Value

The fourth step in discounted cash flow analysis is calculating the terminal value.

We have already calculated the critical components of DCF analysis, except the terminal value. Therefore, we will now calculate the terminal value, followed by the discounted cash flow analysis calculation. There are several ways to calculate the terminal value of cash flows.

However, the most commonly known method is to apply a perpetuity method using the Gordon Growth ModelGordon Growth Model is a Dividend Discount Model variant used for stock price calculation as per the Net Present Value (NPV) of its future dividends. read more to value the company. The formula to calculate the terminal value for future cash flow is:

Terminal Value = Final Year Projected Cash Flow * (1+ Infinite Growth Rate)/ (Discount Rate-Long Term Cash Flow Growth Rate)

Step 5 – Present Value Calculations

The fifth step in discounted cash flow analysis is to find the present values of free cash flows to firm and terminal value.

Find the present value of the projected cash flows using NPV formulas and XNPV formulas.

The projected cash flows of the firm are divided into two parts: –

Explicit Period (the period for which FCFF was calculated – till 2022E)
Period after the explicit period (post 2022E)

Present Value of Explicit Forecast Period (the year 2022)

Calculate the Present Value of the Explicit Cash Flows using WACC derived above

Present Value of Terminal Value (beyond 2022)

Step 6- Adjustments

The sixth step in discounted cash flow analysis is to adjust your enterprise valuation.

Adjustments to the discounted cash flow valuations are made for all the non-core assets and liabilities that have not been accounted for in the free cash flow projections. To find the adjusted fair equity valueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.read more, one may adjust valuation by adding unusual assets or subtracting liabilities.

Common discounted cash flow valuation adjustments include: –

Adjust your valuation for all assets and liabilities. For example, cash flow projections do not account for non-core assets and liabilities. As a result, the enterprise value may need to be adjusted by adding other unusual assets or subtracting liabilities to reflect the company’s fair value. These adjustments include: –

DCF Valuation Summary

Step 7 – Sensitivity Analysis

The seventh step in discounted cash flow analysis is calculating the output’s sensitivity analysisSensitivity analysis is a type of analysis that is based on what-if analysis, which examines how independent factors influence the dependent aspect and predicts the outcome when an analysis is performed under certain conditions.read more.

It is important to test your DCF model with the changes in assumptions. The two of the most important beliefs that have a major impact on valuations are: –

Changes in the infinite growth rate
Changes in weighted average cost of capital

We can easily do Sensitivity Analysis in excelSensitivity analysis in excel helps us study the uncertainty in the output of the model with the changes in the input variables. It primarily does stress testing of our modeled assumptions and leads to value-added insights. In the context of DCF valuation, Sensitivity Analysis in excel is especially useful in finance for modeling share price or valuation sensitivity to assumptions like growth rates or cost of capital.read more using DATA TABLES.

The below chart shows the sensitivity analysis of Alibaba’s DCF valuation model.

We note that the base case valuation of Alibaba is $78.3 per share.
When WACC changes from 9% to say 11%, then the DCF valuation decreases to $57.7
Likewise, if we change the infinite growth rates from 3% to 5%, then the fair DCF valuation becomes $106.5

Conclusion

We know that discounted cash flow analysis helps calculate the company’s value today based on the future cash flow. That is because the company’s value depends upon the sum of the cash flow that the company produces in the future. However, we must discount these future cash flows to arrive at the present value.