{"id":15376,"date":"2022-10-20T13:59:47","date_gmt":"2022-10-20T13:59:47","guid":{"rendered":"https:\/\/valutico.com\/discounted-cash-flow-analysis-your-complete-guide-with-examples\/"},"modified":"2024-01-05T19:54:47","modified_gmt":"2024-01-05T19:54:47","slug":"discounted-cash-flow-analysis-your-complete-guide-with-examples","status":"publish","type":"post","link":"https:\/\/valutico.com\/discounted-cash-flow-analysis-your-complete-guide-with-examples\/","title":{"rendered":"Discounted Cash Flow Analysis\u2014Your Complete Guide with Examples"},"content":{"rendered":"<p><img fetchpriority=\"high\" decoding=\"async\" class=\"alignnone size-full wp-image-12399\" src=\"https:\/\/valutico.com\/wp-content\/uploads\/2022\/10\/Discounted-Cash-Flow-Analysis-Explanation-Valutico-2.jpg\" alt=\"Discounted Cash Flow Method\" width=\"1800\" height=\"666\" \/><\/p>\n<p><span style=\"font-weight: 400;\">This complete guide to the discounted cash flow (DCF) method is broken down into small and simple steps to help you understand the main ideas.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">We\u2019ll walk you through what a discounted cash flow analysis is, what it is used for, as well as what all the distinct terms mean, and provide step-by-step instructions on how to calculate company value, and share price, using the DCF method.\u00a0<\/span><\/p>\n<p><a href=\"#stepByStep\">If you want to read to a step-by-step example of a DCF, skip to the end of the article here.<\/a><\/p>\n<p><a href=\"#cons\">If you want to understand the pro&#8217;s and con&#8217;s, skip down to here.<\/a><\/p>\n<p>If you want to understand the basic logic first, keep reading.<\/p>\n<style>\ntable {border-collapse: collapse; width: 100%!important;}td, th{ border: 1px solid #1f384d; padding: 8px; tr:nth-child(even){background-color: #f2f2f2;}tr:hover{background-color: #ddd;}th{ padding-top: 12px; padding-bottom: 12px; text-align: left; background-color: #04AA6D; color: white;}<\/style>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">What is the Discounted Cash Flow Method?<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">What is the discounted cash flow method? <\/span><b>The discounted cash flow (DCF) method is one of the three main methods for calculating a company\u2019s value. It\u2019s also used for calculating a company\u2019s share price, the value of investments, projects, and for budgeting. The DCF method takes the value of the company to be equal to all future cash flows of that business, discounted to a present value by using an appropriate discount rate. This is because of the <\/b><b><i>time value of money principle, <\/i><\/b><b>whereby future money is worth less than money today. That\u2019s why it\u2019s called a \u2018discounted\u2019 cash flow.<\/b><\/p>\n<p><i><span style=\"font-weight: 400;\">Context of DCF:<\/span><\/i><span style=\"font-weight: 400;\"> There are three main approaches to calculating a company\u2019s value. The first is 1. the intrinsic or <\/span><i><span style=\"font-weight: 400;\">income-based<\/span><\/i><span style=\"font-weight: 400;\"> approach, also known as an entity approach, then there is also 2.\u00a0 the asset-based approach also known as the <\/span><i><span style=\"font-weight: 400;\">cost-based<\/span><\/i><span style=\"font-weight: 400;\"> approach, and finally 3. the multiple based or \u2018<\/span><i><span style=\"font-weight: 400;\">comps<\/span><\/i><span style=\"font-weight: 400;\">\u2019 (comparable company analysis) approach. A DCF analysis is the main income-based approach\u2014an approach based on the company\u2019s own cash flows.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<p>&nbsp;<\/p>\n<p><strong>The DCF Formula<\/strong><\/p>\n<p><span style=\"font-weight: 400;\">We\u2019ll explain what all these terms mean, as well as the logic behind the method, below.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><img decoding=\"async\" class=\"alignnone wp-image-12353 size-full\" src=\"https:\/\/valutico.com\/wp-content\/uploads\/2022\/10\/Discounted-Cash-Flow-Formular-3.png\" alt=\"\" width=\"350\" height=\"220\" \/><\/p>\n<p>&nbsp;<\/p>\n<p><em><span style=\"font-weight: 400;\">DCF<\/span> <span style=\"font-weight: 400;\">=<\/span> <span style=\"font-weight: 400;\">discounted cash flow<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">CF_i<\/span> <span style=\"font-weight: 400;\">=<\/span> <span style=\"font-weight: 400;\">cash flow period i<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">r<\/span> <span style=\"font-weight: 400;\">=<\/span> <span style=\"font-weight: 400;\">interest rate (or discount rate)<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">{n}<\/span> <span style=\"font-weight: 400;\">=<\/span> <span style=\"font-weight: 400;\">time in years before the future cash flow occurs<\/span><\/em><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">In essence, this equation simply adds up all future business cash flows, but discounts each one.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">A discount rate, or discount \u2018factor\u2019, is calculated and applied to each year\u2019s cash flow, in order to arrive at the present value.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">Understanding the Logic Behind a DCF<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><img decoding=\"async\" class=\"alignnone size-full wp-image-12407\" src=\"https:\/\/valutico.com\/wp-content\/uploads\/2022\/10\/Logic-of-Discounted-Cash-Flow.jpg\" alt=\"Logic of DCF\" width=\"1500\" height=\"558\" \/><\/p>\n<h3>Why is it Called \u2018Discounted\u2019 Cash Flow?<\/h3>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Let\u2019s imagine you\u2019re valuing a company that\u2019s going to operate for 3 years and then stop operating.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">How much is it worth?<\/span><\/p>\n<p><span style=\"font-weight: 400;\">You could say it\u2019s worth whatever cash flows it produces, each year, for these 3 years.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Like this:<\/span><\/p>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<table style=\"height: 63px;\" width=\"523\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">Year<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2<\/span><\/td>\n<td><span style=\"font-weight: 400;\">3<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Cash Flow (CF)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$10 million<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$10 million<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$10 million<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">$10 million + $10 million + $10 million.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">No points for working out that this company is worth $30 million.\u00a0<\/span><span style=\"font-weight: 400;\">But here\u2019s the big problem with this basic approach:<\/span><\/p>\n<p><i><span style=\"font-weight: 400;\">Is that predicted $10 million of cash flow in the future, really equal to $10 million in your pocket today?<\/span><\/i><\/p>\n<p><span style=\"font-weight: 400;\">The answer is no, it\u2019s not.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">What\u2019s worth more to you out of $10 today or $10 in three years\u2019 time?<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Your answer is probably the money <\/span><i><span style=\"font-weight: 400;\">right now<\/span><\/i><span style=\"font-weight: 400;\">, and so you can see money today is worth more than money in the future. This actually has a name\u2014it\u2019s called the Time Value of Money (TVM) principle, and there are several reasons for this to be the case:<\/span><\/p>\n<p><i><span style=\"font-weight: 400;\">Uncertainty<\/span><\/i><span style=\"font-weight: 400;\">\u2014future money is not guaranteed.\u00a0<\/span><\/p>\n<p><i><span style=\"font-weight: 400;\">Inflation<\/span><\/i><span style=\"font-weight: 400;\">\u2014you will be able to buy less with that $10 in 3 years.<\/span><\/p>\n<p><i><span style=\"font-weight: 400;\">Investing<\/span><\/i><span style=\"font-weight: 400;\">\u2014you can invest that $10 today, earn, say, 10% interest per year, and in 3 years it will be worth $13.31.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So, to be more accurate in using cash flows to value a business, you\u2019re going to need to discount the money to be received in the future.\u00a0<\/span><span style=\"font-weight: 400;\">In particular, reduce this figure of future cash flow, to bring it in line with what that amount of future money could be said to be worth today.\u00a0<\/span><span style=\"font-weight: 400;\">Only at this point do you add up all the \u2018discounted\u2019 cash flows, to get your company value.\u00a0<\/span><span style=\"font-weight: 400;\">It should now\u2013we hope\u2013be obvious why it\u2019s called a <\/span><i><span style=\"font-weight: 400;\">discounted<\/span><\/i><span style=\"font-weight: 400;\"> cash flow analysis.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">Following the Fundamental Steps in a DCF<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-12414\" src=\"https:\/\/valutico.com\/wp-content\/uploads\/2022\/10\/Steps-to-Discounted-Cash-Flow-Analysis.jpg\" alt=\"Steps to Discounted Cash Flow Analysis\" width=\"1600\" height=\"591\" \/><\/p>\n<p><span style=\"font-weight: 400;\">As just explained, in a DCF analysis, you discount the future cash flows in order to value a company more accurately.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So, by how much do you discount them?\u00a0<\/span><span style=\"font-weight: 400;\">Well, by a certain discount factor.\u00a0<\/span><span style=\"font-weight: 400;\">You then apply this discount factor to each year\u2019s cash flow.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This discount factor is the main method underlying a DCF. Once you apply these discount factors, in essence, you then simply add all the years together\u2013with the factors applied\u2013to give you the value of the business.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The discount factor for each year is calculated as follows:<\/span><\/p>\n<p><span style=\"font-weight: 400;\">1 \/ (1 + r) ^ n<\/span><\/p>\n<p><em><span style=\"font-weight: 400;\">r = discount rate<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">n = number of discount years<\/span><\/em><\/p>\n<p><span style=\"font-weight: 400;\">Looking at it differently, this calculation provides you with a discount factor that tells you how much you\u2019d have to invest today, in order to get to that figure of $10 million in year 1, $10 million in year 2, in year 3, and so on.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Remember, present money can earn interest and be worth more in the future. That is the fundamental principle underlying this method.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h3>Adding A Row for the Discount Factor<\/h3>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Here we will add on a row in our table to illustrate.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">You don\u2019t need to worry exactly how the formula itself works too much to perform the method.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The important figure there is r, which we\u2019re using as the discount rate in this whole equation. In the full DCF, it will often be the WACC, which we\u2019ll come to later. But here, we use what interest we could get from an alternative investment in the market, called the Market Rate. This is the rate of return you\u2019d get if you invested your money today instead.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">In our example, it\u2019s 10%.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">With that r figure plugged into the above formula, you find the discount rate appropriate for each year, as so.<\/span><\/p>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<table style=\"height: 93px;\" width=\"616\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">Year<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2<\/span><\/td>\n<td><span style=\"font-weight: 400;\">3<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Cash Flow (CF)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$10 million<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$10 million<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$10 million<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Discount Factor (using r=10%)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.9<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.83<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.75<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Every year you discount it by a different factor. The further in the future, the more you discount it and thus the lower the discount factor.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Then you simply multiply the cash flow each year by this discount factor.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This provides you with your discounted cash flow figure.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">You get:<\/span><\/p>\n<p>&nbsp;<\/p>\n<table style=\"height: 121px;\" width=\"722\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">Year<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2<\/span><\/td>\n<td><span style=\"font-weight: 400;\">3<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Cash Flow (CF)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">10M<\/span><\/td>\n<td><span style=\"font-weight: 400;\">10M<\/span><\/td>\n<td><span style=\"font-weight: 400;\">10M<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Discount Factor (using Market Rate: r=10%)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.9<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.83<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.75<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Discounted Cash Flow<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$9 million<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$8.3 million<\/span><\/td>\n<td><span style=\"font-weight: 400;\">$7.5 million<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Then if you add them all together, instead of getting $30 million\u2026 you get:\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">$9 million + $8.3 million + $7.5 million =\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">$24.8 million<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This is quite a bit less than the original $30 million figure, so you can see the real impact of the TVM principle and its impact on the DCF approach right there. <\/span><span style=\"font-weight: 400;\">This value is widely referred to as the \u201cNet Present Value\u201d (NPV).\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Congratulations, you have now seen, quite simply, the logic behind a discounted cash flow method.\u00a0<\/span><span style=\"font-weight: 400;\">Does this make sense? <\/span><span style=\"font-weight: 400;\">We hope the underlying logic is fairly clear\u2026<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But, you may have spot something that\u2019s not particularly realistic. <\/span><span style=\"font-weight: 400;\">Businesses often don\u2019t stop operating after year 3. <\/span><span style=\"font-weight: 400;\">In fact, we don\u2019t actually know how many years they\u2019ll operate for.\u00a0<\/span><span style=\"font-weight: 400;\">So, how do we account for the value of the cash flows across all these possible years in the future (which may be forever)?<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Well, the short answer is after that forecast period where we estimate each year\u2019s cash flows then discount them, we add a single number at the end to account for all the theoretical years in the future, called the Terminal Value (TV). We\u2019ll explain how this works next.\u00a0<\/span><\/p>\n<p>But first, a quick aside, which you can feel free to <a href=\"#terminalValue\">skip<\/a> if you want to jump ahead:<\/p>\n<p>&nbsp;<\/p>\n<div style=\"margin: 0 0 100px 200px; background-color: #375d72; color: white; padding: 20px; border-radius: 15px;\">\n<h2 style=\"color: white; font-size: 26px;\">Why Do We Use the Market Rate to Calculate the Discount Factor?<\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">The market rate of return on investing money today, tells us how much more that money will be worth in the future because it earns a return. We add that return on, and get a larger cash value in future years.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Working backwards from this larger value using the market rate can, conversely, tell us how much less money we would have losing, say, 10%, each year.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So, given an annual return of 10% on your invested money, to get $10 million by year 3, right now, in your hand today you\u2019d need $7.5 million. This is because if you invested that today with 10% return every year, by year 3 you would have $10 million.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So, using this method, we can say that $10 million in year 3 is actually only worth $7.5 million today. That\u2019s how much we\u2019d need now to equal $10 million in year 3 (given that 10% market return rate on investing that money today).\u00a0\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This a major way that the \u2018discount\u2019 part in the discounted cash flow, gets done.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">(Let\u2019s pause here to acknowledge the big assumption that \u2018interest rates will be 10% every year\u2019. Obviously, this is an important assumption to try to predict accurately, as it has a sizeable impact on the valuation).<\/span><\/p>\n<\/div>\n<h3><span id=\"terminalValue\">Explaining The Terminal Value<\/span><\/h3>\n<p>&nbsp;<\/p>\n<p><strong>What happens after year 3 of our projected forecast?<\/strong><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">How many years does the company last and what is the total and, more importantly, the Present Value, of these cash flows across these future years?<\/span><\/p>\n<p><span style=\"font-weight: 400;\">We need to know this sum total number so we can add it to the other three years of cash flows, to get the full value of the company\u2019s entire life.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Well, the DCF method uses a number called the Terminal Value to represent this assumed sum total.\u00a0<\/span><span style=\"font-weight: 400;\">This Terminal Value is the number the DCF method uses to represent what the business is worth beyond your initial 3, 5, 10-year (etc.) forecast.\u00a0<\/span><span style=\"font-weight: 400;\">It\u2019s a very important number in a DCF analysis because it represents a large chunk of the total valuation amount.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">\u201cHow do I calculate the Terminal Value?\u201d you may ask.\u00a0<\/span><span style=\"font-weight: 400;\">Well, once more you can rely on a widely used formula.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">FCF<\/span><span style=\"font-weight: 400;\">n<\/span><span style=\"font-weight: 400;\"> x (1 + g) \/ (d &#8211; g)<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">And you need three numbers to do this.\u00a0<\/span><\/p>\n<ul>\n<li><em><span style=\"font-weight: 400;\">FCF<\/span><span style=\"font-weight: 400;\">n<\/span><span style=\"font-weight: 400;\"> is the free cash flow in year <\/span><span style=\"font-weight: 400;\">n, <\/span><span style=\"font-weight: 400;\">\u00a0being the last forecast period <\/span><\/em><\/li>\n<li><em>g is the terminal growth rate.<\/em><\/li>\n<li><em>d is the discount rate (which is usually the weighted average cost of capital (WACC), r in our previous example)<\/em><\/li>\n<\/ul>\n<p><span style=\"font-weight: 400;\">This formula is known as the Gordon Growth formula.<\/span><\/p>\n<p>&nbsp;<\/p>\n<h3>What Happens When We Add the Terminal Value?<\/h3>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Let\u2019s do a quick example to illustrate the portion of the final valuation that is represented by the Terminal Value.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Let\u2019s say the discount rate, using the WACC, is 12% (so, this is a risky business &#8211; the higher the WACC, the riskier the business as investors expect to be compensated for taking on additional risk).<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The terminal growth rate is 1.7%.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">(The growth rate always has to be lower than the growth rate of the economy, otherwise given enough time the company will grow larger than the economy, which doesn\u2019t quite make sense).<\/span><\/p>\n<p><span style=\"font-weight: 400;\">If we plug these values into the above formula, this Terminal Value calculation gives $98.7 million. But remember\u2014you still have to apply the discount factor at the end of the forecast period. Using the WACC of 12% in year 3 provides a discount factor of 0.75 which produces a Net Present Value of the Terminal Value of:<\/span><\/p>\n<p><span style=\"font-weight: 400;\">$74 million.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Can you remember how much our 3-year business was worth before this step? <\/span><span style=\"font-weight: 400;\">It was worth $24.8 million.\u00a0<\/span><span style=\"font-weight: 400;\">So the Terminal Value here is three times as large!\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Incidentally, adding them together gives the total value, which would then be $98.8 million. You can see why the Terminal Value is so important to the valuation as a whole!\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h3>Two Methods to Calculate the Terminal Value<\/h3>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">As mentioned, the Terminal Value is highly important to a DCF valuation because it takes up a large chunk of the whole valuation.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">There are two main methods to calculate what the business is worth after the years of your forecast cash flow. That is\u2013of course\u2013two ways to calculate the Terminal Value.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">As it turns out, one major way is to assume the company will exist forever.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This is the <\/span><i><span style=\"font-weight: 400;\">perpetual growth method<\/span><\/i><span style=\"font-weight: 400;\">, also known as the Gordon Growth Method, which is the one used in the example immediately above and is particularly favored by academics.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The second approach is by assuming the business is sold at that point.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This approach then becomes technically a multiple-based approach, because of the way it works. Practitioners assume the business is sold as a multiple of some financial metric like EBITDA, based on what they can see today for other businesses that were sold, and what these comparable trading multiples are.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Some practitioners will use an average of both methods.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">How to Determine the Correct Discount Rate to use?<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">In this article, we have referred to the discount rate to be used to discount the future cash flows as the Market Rate (r) or generally as the discount rate (d).\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The principle behind determining the correct discount rate to use is that the discount rate needs to <\/span><i><span style=\"font-weight: 400;\">adequately reflect the riskiness of the business being valued<\/span><\/i><span style=\"font-weight: 400;\">.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">In most DCF analysis, practitioners make use of the Capital Asset Pricing Model (CAPM) to calculate a discount rate that reflects the riskiness of the business being valued. The details of how the CAPM works is beyond the scope of this article but in short, the formula is as follows:<\/span><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">Ce = Rf + B x (Rm &#8211; Rf) + Cp<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><em><span style=\"font-weight: 400;\">Ce = Cost of Equity<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">Rf = Risk-free Rate<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">B = Beta<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">(Rm &#8211; Rf) = Equity Market Risk Premium<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">Cp = Cost of Equity Premium<\/span><\/em><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">If the WACC is used to discount the cash flows (more on this below), then it is calculated as follows:<\/span><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">WACC = Ce x [E\/(D+E)] + Cd x (1-t) x [D\/(D+E)]<\/span><\/p>\n<p>&nbsp;<\/p>\n<p><em><span style=\"font-weight: 400;\">Ce = Cost of Equity<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">E = Equity\u00a0<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">D = Debt<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">Cd = Cost of Debt<\/span><\/em><\/p>\n<p><em><span style=\"font-weight: 400;\">t = Tax Rate<\/span><\/em><\/p>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">How to Value Stocks Using DCF?<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Valuing stocks using DCF is pretty much the same method when valuing a company but you just take one extra step.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Once you have added all your future discounted cash flows together, you get the value of the business today. Then you simply divide this figure by the number of shares.\u00a0<\/span><span style=\"font-weight: 400;\">So if we take our example from before and we know they\u2019ve issued 10,000,000 shares. We divide the value of the company by 10,000,000, so we get $9.88 per share.\u00a0<\/span><span style=\"font-weight: 400;\">This gives us our own unique determination of what the share price should be.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">The 5 Major Steps to Calculate a DCF<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Really, conducting a DCF is just like following a recipe.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">There are some simple steps to take, and these are often done in MS Excel.\u00a0<\/span><span style=\"font-weight: 400;\">Or, if you have a tool like Valutico, then you just need to enter some key figures and the software does all the work.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But if you want to be able to go through the steps yourself, let\u2019s do that now.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Here is a recommended order of steps to follow:\u00a0<\/span><\/p>\n<p><b>Step 1<\/b><span style=\"font-weight: 400;\">. Forecast cash flow. (\u2018free cash flow\u2019)<\/span><\/p>\n<p><b>Step 2<\/b><span style=\"font-weight: 400;\">. Calculate the discount rate. Often, the Weighted Average Cost of Capital (WACC) is used*.\u00a0<\/span><\/p>\n<p><b>Step 3<\/b><span style=\"font-weight: 400;\">. Calculate the Terminal Value.\u00a0<\/span><\/p>\n<p><b>Step 4<\/b><span style=\"font-weight: 400;\">. Discount the cash flow. Discount the Terminal Value.\u00a0<\/span><\/p>\n<p><b>Step 5<\/b><span style=\"font-weight: 400;\">. Add up all the figures you have to arrive at the Net Present Value. Depending on the exact methodology and discount rate used, this could be the Enterprise Value or Equity Value.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">*the WACC is one popular discounted cash flow method (DCF WACC). However there are other methods.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">Why Would You Use a DCF Model?<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">DCF is widely used in valuing companies, and it is used widely in valuing stocks as well. But it can be used in several ways, including to:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Value a business you want to sell, or for a business you want to purchase.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Value a company\u2019s stock price to compare it to the actual stock price, as one piece of information to help you decide whether to invest.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Value a project.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Assess the impact of an initiative, like a cost-saving programme or entering a new market.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Use for internal financial planning and accounting (FP&amp;A) purposes, such as budgeting, and forecasting.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Allow a company to raise money.<\/span><\/li>\n<\/ul>\n<p>&nbsp;<\/p>\n<h2><span id=\"cons\" style=\"font-weight: 400;\">Problems with a Discounted Cash Flow Analysis<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">No approach to valuing a company or stocks is completely perfect.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Just remember, when valuing you are making educated guesses about the future.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">If you get these educated guesses wildly incorrect, then your valuation will likely also be off.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But let\u2019s take a closer look at some of the drawbacks specific to the DCF approach.\u00a0<\/span><\/p>\n<p><b>Garbage in. Garbage out.\u00a0<\/b><\/p>\n<p><i><span style=\"font-weight: 400;\">Cash flow: <\/span><\/i><span style=\"font-weight: 400;\">A lot hinges on getting these cash flow projections correct. It might be quite straightforward to project cash flow for year 1, but when you get to year 2, and especially years 3, 4, 5 and beyond, in many industries this becomes almost impossible to predict with a high degree of certainty. Some industries like oil and gas might lend themselves to you having a longer forecast period of say 10 years, but even these industries are subject to the unknown future. When you\u2019re trying to predict cash flow for many businesses in 5 years\u2019 time it can be particularly difficult, and becomes closer to complete guess-work.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Moreover, year 4 cash flows are determined by year 3 cash flows, as that is the way the business works. Year 5 by the year before, and so on. If you make a mistake in the early years, this deviation can be magnified in the future. Small variations early on are magnified later.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">Strengths of a Discounted Cash Flow Analysis<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">The DCF approach is widely used and considered a strong approach for valuing a company or stocks. Many would call it the leading approach. Here are some of the main reasons:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">It is a so-called \u2018intrinsic\u2019 approach based on data that directly reflects the company\u2019s actual financial performance.\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">It allows the practitioner to consider multiple distinct financial performance scenarios, whereby they can compare different possible futures based on making different assumptions.\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Relying on cash flow data, it incorporates a wide range of important financial metrics, such as net income, working capital, and capital expenditure.\u00a0<\/span><\/li>\n<\/ul>\n<p>&nbsp;<\/p>\n<h2><span style=\"font-weight: 400;\">What are the Different DCF Methods?<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">This article has outlined the simple form of a DCF analysis. However, there are multiple versions that differ in how they are calculated and when they should be applied:<\/span><\/p>\n<ul>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">DCF WACC (simplified)\u2014largely what this article has been describing, your basic DCF which calculates Free Cash Flow to the Firm and discounts these cash flows using the WACC as the discount whilst keeping a constant capital structure (D\/E ratio) throughout the forecast period.\u00a0<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">DCF WACC\u2014similar to the above except that it calculates a different WACC in each forecast period based on a changing capital structure (D\/E) and thus a changing beta in each period.<\/span><\/li>\n<li style=\"font-weight: 400;\" aria-level=\"1\"><span style=\"font-weight: 400;\">Flow to Equity &#8211; this calculates the Free Cash Flow to Equity and discounts these cash flows using the Cost of Equity.<\/span><\/li>\n<\/ul>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">Note that in theory the above three approaches should deliver an identical valuation result thus the choice of what method to use is simply down to the level of information at hand and personal preference.<\/span><\/p>\n<p>&nbsp;<\/p>\n<h2><span id=\"stepByStep\" style=\"font-weight: 400;\">A DCF Example \u2013 Each Step in a DCF Calculation in Order<\/span><\/h2>\n<p>&nbsp;<\/p>\n<p><img loading=\"lazy\" decoding=\"async\" class=\"alignnone size-full wp-image-12421\" src=\"https:\/\/valutico.com\/wp-content\/uploads\/2022\/10\/DCF-example-steps-scaled.jpg\" alt=\"DCF Example Steps\" width=\"2560\" height=\"962\" \/><\/p>\n<p><span style=\"font-weight: 400;\">In practice, you can calculate a DCF using MS Excel. However, if you do multiple valuations throughout the year, or valuations you want to update regularly, then a tool like Valutico makes things significantly easier.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">To understand the steps, let\u2019s go through each in turn with our DCF example.\u00a0<\/span><\/p>\n<p>&nbsp;<\/p>\n<h3>Step 1. Cash Flow<\/h3>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">You need the \u2018unlevered\u2019 cash flow*. <\/span><span style=\"font-weight: 400;\">To calculate this free cash flow (FCF), you need to add up the following figures (you do not add the tax rate, that is shown below as it\u2019s used to calculate the tax amount).\u00a0<\/span><\/p>\n<h1><\/h1>\n<table style=\"height: 245px;\" width=\"350\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">EBIT<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5,000<\/span><\/td>\n<\/tr>\n<tr>\n<td><i><span style=\"font-weight: 400;\">Tax Rate<\/span><\/i><\/td>\n<td><i><span style=\"font-weight: 400;\">25%<\/span><\/i><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Tax (from tax rate and EBIT)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">-1250<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Depreciation<\/span><\/td>\n<td><span style=\"font-weight: 400;\">100<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Amortization<\/span><\/td>\n<td><span style=\"font-weight: 400;\">225<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">CapEx<\/span><\/td>\n<td><span style=\"font-weight: 400;\">-1,550<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Non-cash working capital<\/span><\/td>\n<td><span style=\"font-weight: 400;\">-180<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>FCF<\/b><\/td>\n<td><b>2,345<\/b><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">The CapEx, tax, and in this case non-cash working capital, are negative.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Add these to get the free cash flow for that single year (or particular period, like 6 months). Step 1 done.\u00a0<\/span><\/p>\n<p><em><span style=\"font-weight: 400;\">*You can also do a different \u2018levered\u2019 cash flow method (Free Cash Flow to Equity), which &#8216;in theory&#8217; at least should provide the same outcome, but unlevered is the more commonly used. Unlevered is the operating cash flows (Free Cash Flow To Firm), whereas levered is the cash flows available to shareholders once other claims (i.e. debt) has been paid.\u00a0<\/span><\/em><\/p>\n<p>&nbsp;<\/p>\n<h3>Step 2. Discount Rate<\/h3>\n<h3><\/h3>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Now, we need to calculate the discount rate.\u00a0<\/span><span style=\"font-weight: 400;\">We will use the CoE and WACC formulas described above.\u00a0<\/span><span style=\"font-weight: 400;\">Therefore, we can put in the following values:<\/span><\/p>\n<h1><\/h1>\n<table style=\"height: 247px;\" width=\"378\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">Equity<\/span><\/td>\n<td><span style=\"font-weight: 400;\">17,500<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Debt<\/span><\/td>\n<td><span style=\"font-weight: 400;\">15,000<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Cost of Debt<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5%<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Tax rate<\/span><\/td>\n<td><span style=\"font-weight: 400;\">25%<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Risk free rate (can use 10y Treasury)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1.5%<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Beta\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1.3<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Market Return<\/span><\/td>\n<td><span style=\"font-weight: 400;\">10%<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Cost of Equity<\/span><\/td>\n<td><span style=\"font-weight: 400;\">12.55%<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">We had to calculate the Cost of Equity using the CAPM method as previously described. <\/span><span style=\"font-weight: 400;\">Now, we\u2019ve got that, we can move onto two core components of the WACC equation, to finally give the WACC.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">This is:<\/span><\/p>\n<h1><\/h1>\n<table style=\"height: 93px;\" width=\"293\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">Debt \/ Debt + Equity<\/span><\/td>\n<td><span style=\"font-weight: 400;\">46.15%<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Equity \/ Debt + Equity<\/span><\/td>\n<td><span style=\"font-weight: 400;\">53.85%<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>WACC<\/b><\/td>\n<td><b>8.49%<\/b><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p>Finally, we have our discount rate.<\/p>\n<p>&nbsp;<\/p>\n<h3>Step 3. Terminal Value.<\/h3>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Now, we need the Terminal Value.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">There are two methods, and one option is to combine them both and use the average.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">First, the perpetuity growth method (or Gordon Growth model).<\/span><\/p>\n<p><span style=\"font-weight: 400;\">And then, the exit multiple.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">The perpetuity growth formula is:<\/span><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">Free Cash Flow on last year + 1 \/ (discount rate \u2013 growth rate)<\/span><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">So we need:<\/span><\/p>\n<h1><\/h1>\n<table style=\"height: 92px;\" width=\"271\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">WACC<\/span><\/td>\n<td><span style=\"font-weight: 400;\">8.49%<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Growth Rate<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1.70%<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">EV\/EBITDA Multiple<\/span><\/td>\n<td><span style=\"font-weight: 400;\">7<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">The WACC we need because it\u2019s our discount rate in this equation.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">But we also need the free cash flow from the last year.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So here is the EBITDA and FCF year on year for our entire 5-year forecast period:<\/span><\/p>\n<h1><\/h1>\n<table style=\"height: 96px;\" width=\"389\">\n<tbody>\n<tr>\n<td><span style=\"font-weight: 400;\">Period<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2<\/span><\/td>\n<td><span style=\"font-weight: 400;\">3<\/span><\/td>\n<td><span style=\"font-weight: 400;\">4<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">EBITDA<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5,325<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5,530<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5,730<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5,820<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5,820<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">FCF<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,345<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,510<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,720<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,795<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,800<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">Then taking these we get the following:<\/span><\/p>\n<h1><\/h1>\n<table style=\"height: 153px;\" width=\"305\">\n<tbody>\n<tr>\n<td><b>TERMINAL VALUE<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">EBITDA<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5,820<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Exit Multiple (EV\/EBITDA)<\/span><\/td>\n<td><span style=\"font-weight: 400;\">40,740<\/span><\/td>\n<\/tr>\n<tr>\n<td><span style=\"font-weight: 400;\">Perpetuity Growth<\/span><\/td>\n<td><span style=\"font-weight: 400;\">41,948<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>Average<\/b><\/td>\n<td><b>41,344<\/b><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h3><\/h3>\n<p>&nbsp;<\/p>\n<h3>Step 4. Putting it all together.<\/h3>\n<h3><\/h3>\n<p>&nbsp;<\/p>\n<p>Now that we have the WACC and the Terminal Value, we can do the discounting.<\/p>\n<p><span style=\"font-weight: 400;\">Both the free cash flows, and the Terminal Value need to be discounted.<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Then we sum these, and get the Enterprise value (EV).\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Let\u2019s go.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Remember, the discount factor equation is:<\/span><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">Discount factor = 1 \/ (1 + r)^n<\/span><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">In this case, we have chosen to use WACC for r.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">So we get the following:<\/span><\/p>\n<h1><\/h1>\n<table style=\"height: 273px;\" width=\"521\">\n<tbody>\n<tr>\n<td><b>Period<\/b><\/td>\n<td><\/td>\n<td><span style=\"font-weight: 400;\">1<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2<\/span><\/td>\n<td><span style=\"font-weight: 400;\">3<\/span><\/td>\n<td><span style=\"font-weight: 400;\">4<\/span><\/td>\n<td><span style=\"font-weight: 400;\">5<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>FCF<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,345<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,510<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,720<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,795<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,800<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>Terminal Value<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">41,344<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>Discount Factor<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.92<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.85<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.78<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.72<\/span><\/td>\n<td><span style=\"font-weight: 400;\">0.67<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>\u00a0<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>PV of FCF<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,162<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,133<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,130<\/span><\/td>\n<td><span style=\"font-weight: 400;\">2,018<\/span><\/td>\n<td><span style=\"font-weight: 400;\">1,863<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>PV of TV<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">27,510<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>\u00a0<\/b><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<\/tr>\n<tr>\n<td><b>Enterprise Value<\/b><\/td>\n<td><span style=\"font-weight: 400;\">37,815<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<td><span style=\"font-weight: 400;\">\u00a0<\/span><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<h1><\/h1>\n<p>&nbsp;<\/p>\n<p><span style=\"font-weight: 400;\">And this enterprise value is the value of the business.\u00a0<\/span><\/p>\n<p><span style=\"font-weight: 400;\">Congratulations, if you worked along, you have now valued a business using the DCF method.<\/span><\/p>\n<h1><\/h1>\n<p><span style=\"font-weight: 400;\">If you perform multiple valuations per year, and valuations are a significant part of the work you do, then using a tool that automates most of the process can make your life much easier. Try <a href=\"https:\/\/valutico.com\/book-a-demo\/\">booking a demo<\/a>, if this applies to you. Otherwise, we hope the explanation above has helped you wrap your head around what a DCF analysis is, and how to use one.<\/span><\/p>\n","protected":false},"excerpt":{"rendered":"<p>This complete guide to the discounted cash flow (DCF) method is broken down into small and simple steps to help you understand the main ideas.\u00a0 We\u2019ll walk you through what a discounted cash flow analysis is, what it is used for, as well as what all the distinct terms mean, and provide step-by-step instructions on [&hellip;]<\/p>\n","protected":false},"author":14,"featured_media":22641,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"inline_featured_image":false,"footnotes":""},"categories":[252,251,226],"tags":[],"ppma_author":[264],"yoast_head":"<!-- This site is optimized with the Yoast SEO Premium plugin v21.9 (Yoast SEO v22.4) - https:\/\/yoast.com\/wordpress\/plugins\/seo\/ -->\n<title>Discounted Cash Flow Analysis\u2014Your Complete Guide with Examples - Valutico<\/title>\n<meta name=\"description\" content=\"The discounted cash flow (DCF) method is one of the three main methods for calculating a company\u2019s value. 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