Considerations in DCF Financial Modeling.pdf - garcialellith
What are the Considerations in Discounted Cash Flow Modeling for your Business Valuation? The Discounted Cash Flow (DCF) model is one of the widely used valuation methods. Investors and financial analysts prefer the detailed and meticulous approach of the model. Significant factors are considered for the DCF model, including the free cash flows, discount rate, projection period, and terminal value. Unlevered cash flow is widely used for DCF as it reflects both the interest of equity and debt holders. On the other hand, levered cash flow shows the available cash after deducting the financial debt (loan repayments and interest). And it is mainly utilized by equity investors and analysts in evaluating investments. Unlevered free cash flows are discounted back to their present value using a discount rate, usually the Weighted Average Cost of Capital (WACC). The farther into the future, the lower the discount factor resulting in lower value of cash flows. Considering the time value of money is one of the upper hands of the DCF model since we know that the purchasing power of the same amount of money today won't be as valuable in the future. Despite the advantages of the DCF model, it also has its share of disadvantages. There are instances where unrealistic assumptions or flawed analyses are made in DCF financial modeling. DCF model can also be complex to others with no deep finance backgrounds. Let's evaluate below what composes the DCF model to help us understand better how the financial model works. Three Major Components of Discounted Cash Flow Model 1. Future Cash Flow Projections Expected future benefits, usually in 5-10 years, are discounted back to their present value. Higher discounted cash flows than the initial investment mean that the investment is worthwhile to invest in. 2. Discount Rate Calculation The most used discount rate is WACC (Weighted Average Cost of Capital). It considers both the costs of equity and debt. It is safe to estimate the cost of debt since it is based on the loan interest rate. On the other hand, the equity rate of return is quite tricky to estimate. The cost of equity includes the risk-free rate (usually based on the government-issued instruments), market-risk premium, and beta (the covariance of a stock's return against the overall market). The discount rate is the expected rate of return of similar-risk investments. 3. Terminal Value Computation There are two methods in computing for terminal value: Exit Multiple Method and Perpetual Growth Method. a. Exit Multiple Method This method assumes that the business will be sold in the future. One way to compute is through Enterprise Value/EBITDA multiple. You can use an average EV/EBITDA multiple within your industry. b. Perpetual Growth Method Perpetual Growth Method assumes that a business grows at a constant rate forever, which is a nearly unrealistic assumption, especially for high growth businesses. The problem with this is how to make accurate estimates of future cash flows into perpetuity. DCF Model is one of the most utilized valuation models. Despite its limitations, the DCF model proves to be a valuable financial planning tool when deciding on an investment. A careful examination and due diligence should be done to check the assumptions and financial model preparation.