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Discounted cash flow analysis (DCF)

OVERVIEW

The discounted Cash flow model calculates an Enterprise value on the basis of its ability to generate free Cash flow. To compute the Enterprise value, the free Cash flows are discounted (see discounting) at a rate that reflects the Risk carried by the operating assets. The DCF model gives the intrinsic value (called intrinsic value – share) of the company.

FORECAST PERIOD

The first thing you need to do when you are building a DCF analysis, is to determine the "forecast period". What is your DCF horizon? This will depend on many things, but usually, the longer the better! Be extra-careful when you decide your forecast period. If you are trying to find the value of a gold mine, bare in mind, that there is a "deadline" to this business. At some point in time, the mine will run out of gold. Don't choose a forecast period of 10 years, if you know that the gold mine has reserve for only 5. At the same time, for most businesses, you won't be able to project financials passed a certain period of time. Who can predict the future in 20 years? This, again depends on the type of business/ asset you are looking at. An infrastructure asset tends to be more easy to predict than a tech company. While you know your DCF horizon/ forecast period, you need to project your financials: i) revenue, ii) costs and iii) cash items. Here are the main aggregates you will need to forecast for your DCF: Revenue EBITDA (then operating costs: COGS and SG&A) EBIT (then D&A) Working Capital (or more importantly variation in working capital) Capital expenditure Forecasting these aggregates, will take particular care and attention to growth rate (impacting revenue), cost evolution (impacting EBITDA and EBIT margins) and capital expenditure (how much you actually spend to sustain and grow the business).

FORECASTING FREE CASH FLOWS

With the different financial aggregates you calculated, you will be able to calculate the Free Cash Flows ("FCF"). FCF are the core bone of your DCF, so make sure they make sense (no massive increase or decrease of FCF for no explainable reasons). Here is a quick reminder of what the FCF "formula" is: + EBITDA - tax calculated on EBIT: EBIT * t - capital expenditure - variation of working capital

DISCOUNT RATE

Once you have the projections of FCF, you will want to discount them, using an appropriate discount rate. For a DCF, the discount rate is the weighted average cost of capital ("WACC"). The WACC is the average of the returns expected by the different financing sources the company/ business has. The WACC is the average return expected by i) equity providers and ii) debt providers.

TERMINAL VALUE AND CALCULATION OF ENTERPRISE VALUE

The terminal value is the value of the business at the end of the forecast period (be careful, there might not be any terminal value, remember the gold mine!). You have 2 ways of calculating the terminal value, but read through the guide on this page to have more information. The last thing you need to do, is discounting the FCF and terminal value using the WACC. You will end up finding the Enterprise Value of the business. Simple!

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