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DCF is a direct valuation technique that values a company by projecting its future cash flows and then using the Net Present Value NPV method to value those cash flows. In a DCF analysis, the cash flows are projected by using a series of assumptions about how the business will perform in the future, and then forecasting how this business performance translates into the cash flow generated by the business—the one thing investors care the most about.
DCF should be used in many cases because it attempts to measure the value created by a business directly and precisely. It is thus the most theoretically correct valuation method available: DCF is probably the most broadly used valuation technique, Cash flow stream essay because of its theoretical underpinnings and its ability to be used in almost all scenarios.
However, DCF is fraught with potential perils. If even one key assumption is off significantly, it can lead to Cash flow stream essay wildly different valuation.
This is quite possible, given that DCF involves predicting future events forecastingand even the best forecasters will generally be off by some amount. Therefore, DCF should generally only be done alongside other valuation techniques, lest a questionable assumption or two lead to a result that is substantially different from what market forces are indicating.
When doing a DCF analysis, a useful checklist of things to do has a mnemonic that is easy to remember: Validate key assumptions for projections. Sensitize variables driving projections to build a valuation range.
When performing a DCF analysis, a series of assumptions and projections will need to be made. Ultimately, all of these inputs will boil down to three main components that drive the valuation result from a DCF analysis.
Free Cash Flow Projections: The cost of capital Debt and Equity for the business. This rate, which acts like an interest rate on future Cash inflows, is used to convert them into current dollar equivalents.
The value of a business at the end of the projection period typical for a DCF analysis is either a 5-year projection period or, occasionally, a year projection period. The DCF valuation of the business is simply equal to the sum of the discounted projected Free Cash Flow amounts, plus the discounted Terminal Value amount.
There is no exact answer for deriving Free Cash Flow projections.
It is very easy to increase or decrease the valuation from a DCF substantially by changing the assumptions, which is why it is so important to be thoughtful when specifying the inputs.
We will discuss WACC calculations in detail later in this chapter. Terminal Value is the value of the business that derives from Cash flows generated after the year-by-year projection period. It is determined as a function of the Cash flows generated in the final projection period, plus an assumed permanent growth rate for those cash flows, plus an assumed discount rate or exit multiple.
More is discussed on calculating Terminal Value later in this chapter. An Unlevered DCF involves the following steps: Value obtained is the Enterprise Value of the business. By comparison, a Levered DCF involves the following steps: Value obtained is the Equity Value aka Market Value of the business.
UFCF is the industry norm, because it allows for an apples-to-apples comparison of the Cash flows produced by different companies.
This means that the LFCF analysis will need to be re-run if a different capital structure is assumed. In effect, UFCF allows the analyst to separate the Cash flows produced by the business from the structure of the ownership and liabilities of the business.
Which is more sensitive part of a DCF model: Free Cash Flows or Discount Rate? The analyst should test several reasonable assumption scenarios to derive a reasonable valuation range. Making important assumptions based upon insufficient research.
Lack of footnotes and details documenting the thought process and research process behind the assumptions chosen.
The further these numbers are projected out, the less visibility the forecaster will have in other words, later projection periods will typically be subject to the most estimation error.
Terminal Value is calculated using one of two methods: Note that if the Perpetuity Method is used, the Discount Rate from the following step will be needed.
Use Net Present Value: Here is a graphical representation of these DCF Steps: The following sources can help provide needed information to produce a high-quality DCF analysis: The Risk Free Rate:Cash flow statement problems and solutions direct method. Published by at 26/11/ Categories.
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Solutions Manual CHAPTER 2 FINANCIAL STATEMENTS AND CASH FLOW Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet.