The Discounted Cash Flow method (DCF method) is a valuation method that can be used to determine the value of investment objects, assets, projects, et cetera. This valuation method is especially suitable to value the assets or stock of a company (or enterprise or firm). A business valuation is required in cases of a company sale or succession, a buy-in or buy-out of a shareholder, divorce, disputes with tax authorities, legal procedures, et cetera. The Discounted Cash Flow method is regarded as the most justifiable method to appraise the economic value of an enterprise.
Note that there are several alternatives of the Discounted Cash Flow method: the WACC method, the Adjusted Present Value method or the Cash To Equity method. All these Discounted Cash Flow methods have in common that (a) future cash flows are determined and (b) these future cash flows are -in one way or another- adjusted for the time value of money, i.e. discounted to a predetermined valuation moment.
In this article, the most commonly used WACC method is explained. This WACC method is often seen as the (one and only) Discounted Cash Flow method. According to this method, so-called free cash flows are discounted at a WACC discount rate. In which WACC represents the Weighted Average Cost of Capital. How this works? We come to that soon!
Non Discounted Cash Flow methods
But first some words about the Discounted Cash Flow method in comparison with other enterprise valuation methods. Valuation experts have developed many ways to say something meaningful about enterprise value. So, there are many other non-Discounted Cash Flow valuation methods in practice. Then the value of a company or its equity is based on book value, assets value, market value, multiples, historic profitability, et cetera. The great advantage is the relative simplicity. Besides, the facts on which the valuation is based can be found in the financial history. So, this makes them less vulnerable to complex discussion about the starting points. The great disadvantage is the relative inaccuracy. So, these non-Discounted Cash Flow methods are more or less a quick but attackable win.
As said, most of these non Discounted Cash Flow methods are based on historical performance. And this is more or less irrelevant. A buyer of a company does not buy a financial history. He buys the future financial performance. More correctly formulated: the future cash flows.
One might think (and hope) that historical performance is normative for the future financial performance. If so, alternative valuation methods (such as the earnings based method) have some significance. But the future is not entirely certain. And more often: different then the past. The value as an outcome of the Discounted Cash Flow method however is based on future cash flows. That is therefore the most justifiable approach: a buyer (or interested party) buys future cash flows with his capital expenditure for the investments in assets or stock.
The value of the company is therefore a derivative of those future cash flows. With the so-called WACC method, we establish the so-called free cash flows. Or, sometimes denoted as the cash to the firm. These are the cash flows that become available for all providers of capital. Not only the buyer (or shareholder) of the shares has invested money (as equity) in the company. But often also interest based capital providers, such as banks, leasing companies, and so on.
We must therefore compare these free cash flows FCF with the total cost of invested capital. This is how we arrive at the total cost of capital: the Weighted Average Cost of Capital (WACC). So, two aspects therefore play a dominant role in the WACC method. These are (a) the future free cash flows FCF which are generated by the enterprise and (b) the Weighted Average Cost of Capital WACC. In this article, the backgrounds and explanations of the Discounted Cash Flow method are elaborated.
Free cash flows
First of all, the free cash flow is the cash flow to the firm. These cash flows are (or will be) available to all providers of the total of invested capital: equity and interest-bearing debt. The free cash flow can be calculated, starting from the operating profit (EBIT) MINUS the (fictional) income tax on this EBIT PLUS the depreciation on fixed assets MINUS the change in provisions MINUS the investment in net induced working capital MINUS the investments in fixed assets.
The Discounted Cash Flow method is all about future cash flows. Future cash flows are definitely different from future profits. Because profit is not yet cash: often stuck in debtors, work in progress and stock. That is why most valuation experts agree that only the Discounted Cash Flow method is economically correct. The valuation method based on profitability, such as the earning value method, is theoretically less correct in calculating the economical value.
The free cash flow can also be calculated via another route. For instance, starting from the bottom line: the companies’ net profit. Note that profit includes the depreciation of fixed assets or amortizations. These are so-called non-cash items. This also applies to additions to provisions, for instance for future expenses. One can add those non-cash items to the net profits to calculate the free cash flows. But the company may also have to invest in fixed assets such as machines or inventory. These expenses should again be deducted. Or perhaps the business is growing. Then more net working capital is needed: debtors, work in progress, stock and finished goods minus creditors. These mutations must be taken into account for the determination of the future free cash flows, i.e. the cash flows that can be distributed among all providers of the capital.
Anyway, with a bit of sense and understanding of the future business, one can calculate the free cash flows with a some accuracy. How this works will be explained later.
Forecast period
So, in order to apply the Discounted Cash Flow method, one has to calculate those free cash flows. For this, we make a multi-year business plan and a financial forecast for the company. That is the trickiest part of the Discounted Cash Flow method. Because, what will happen in the future is highly uncertain. And basing a value on uncertain facts is therefore highly questionable.
That is also the weakest point of the Discounted Cash Flow method. Some opinion leaders indicate a trend in which the Discounted Cash Flow method loses usability. Particularly due to the increased dynamics of the business environment and the related unpredictability of future financial performance of enterprises (companies and projects). In this article I not will discuss the philosophical ideas here.
Back to practicing the Discounted Cash Flow method. And as an example we take an SME company: the privately held limited liable company BriWiFra. BriWiFra is the company of Brian: Brian’s Window Frames. BriWiFra produces hardwood window frames for the construction industry.
And BriWiFra forecasts the following incomes in the next year 1 to year 3 (rounded in €/1000). As a reference year 0 is given: the past year.
Income in €/1000 | Yr 0 | Yr 1 | Yr 2 | Yr 3 |
Turnover | 6000 | 6200 | 6400 | 6600 |
Cost of goods sold | 2550 | 2635 | 2720 | 2805 |
Operating costs | 2920 | 2988 | 3075 | 3113 |
whereof: Depreciations | 150 | 160 | 170 | 175 |
Operating income | 530 | 578 | 605 | 683 |
Interest expense | 68 | 61 | 54 | 47 |
Pretax income | 462 | 516 | 551 | 636 |
Profit tax 25% | 115 | 129 | 138 | 159 |
Net income | 346 | 387 | 413 | 477 |
In addition, a financial forecast of the assets and liabilities can be outlined. This is based on market knowledge and operational performance. This is presented in following balance sheet forecast (rounded in €/1000):
Balance sheet in €/1000 | Yr 0 | Yr 1 | Yr 2 | Yr 3 |
Cash | 20 | 202 | 435 | 712 |
NWC | 1020 | 1080 | 1115 | 1170 |
Fixed assets | 1200 | 1225 | 1250 | 1275 |
Total assets | 2240 | 2507 | 2800 | 3157 |
Debt | 1080 | 960 | 840 | 720 |
Equity | 1160 | 1547 | 1960 | 2437 |
Total liabilities | 2240 | 2507 | 2800 | 3157 |
The NWC is the net working capital: stock, work in progress, accounts receivables (like debtors) minus accounts payable (like creditors). These forecast must be checked whether they are sufficiently feasible and achievable. If so, the free cash flow forecast can be calculated. This is based on arithmetic as given earlier. When a profit tax rate of 25% is applicable, these free cash flows are then as follows:
Free cash flows FCF | Yr 1 | Yr 2 | Yr 3 | |
FCF | 348 | 394 | 432 |
Based on these outcomes, the enterprise value, as a result of these cash flows can be calculated. At this point, we assume the WACC to be 16%. Note that the calculation of a WACC is rather complex and also iterative. But we come to that later.
Based on this, the enterprise value adds up to 872 rounded, as follows:
FCF | 348 | 394 | 432 |
WACC =16% | 0.86 | 0.74 | 0.64 |
NPV | 300 | 293 | 277 |
De NPV is the so-called Net Present Value. These add up to 870: the sum of the three Net Present Values NPV in year 1 through year 3.
A first important step has been taken. We have calculated the future free cash flows. And in particular over the upcoming forecasting period, year 1 through year 3. This period is often denoted as the forecasting period. In the forecasting period, these cash flows are based on certain expectations. We know future events during the forecasting period. And we can derive the business economic consequences from them.
Note that this needs to be reliable to a sufficient extent. So, is the expected annual growth of more than 3% attainable? Can this be done with the preservation of the gross margin? Are investments in fixed assets correctly prognoses? Et cetera
If something might happen that negatively affects the business, then this should be taken into account when calculating the future free cash flows. Otherwise, this would undermine the reliability of the valuation outcome according to the Discounted Cash Flow method. But let us assume this is not the case. Thus: so far so good!
Remainder period
Of course it is likely that after the forecasting period (in our case: 3 years) the enterprise still will generate cash flows. This is plausible since the business is not expected to discontinue. The period after the forecasting period is called the remainder period. And, clearly, the cash flows during this remainder period contribute to the company’s value.
However, the remainder period is beyond our horizon. We have no precise notion about what will be going on then. But not taking any future cash flow in account would be reasonably unfair and incorrect. So, we must make some assumptions on the future cash flows during the remainder period
This is, however, subject to many discussions when applying the Discounted Cash Flow method. A company that -after the forecasting period- has lost its market position to its competitors will generate only little free cash flows. But a company that still shows a crescendo growth after the forecasting period – due to internal or external circumstances – certainly performs significantly better.
Anyway, we have to develop a view on the future during the remainder period. Is it likely that the business will be continued based the same revenue model? For what time period? Perhaps we must work with different standards here. Many approaches are applicable at this point. For example, apply a higher WACC or limit the remainder period in time. Here, a good understanding of the internal conditions and the external environment will help to present justifiable expectations of the future financial performance.
What so ever, the economical value of the future cash flows during the remainder period is denoted as residual value, terminal value or continuing value. In this article, we will use the term terminal value.
Cash flows during the remainder period
Often, a number of assumptions are made for the estimation of free cash flows during the remainder period. Of course, these assumptions must be supported by realistic expectations. If not, they are not credible and will negatively affect the reliability of the valuation outcome.
For example, it is often assumed that the free cash flows in the remainder period will continue infinitely in the future. That is of course not very much realistic. Like products, companies have a finite life. Upcoming technologies, substitute products, competition will all affect, and mostly shorten, the life cycle.
But, one could argue that the value of these free cash flows at the end of year 3 can be calculated with the formula for a perpetual of future cash flows. So, the economic enterprise value at the end of year 3 = FCF in year 4 DIVIDED by WACC. This is a commonly used approach and often practiced in valuation processes. This could be correct, but again, it needs proper justification.
So, if we assume the free cash flows FCF of BriWiFra in year 4 is 512 and perpetual of character, the economic value is 512/16% = 3200.
Note that this is the value of these future free cash flows per the end of the forecasting period. In order to determine the residual value per valuation moment, we have to discount that to valuation moment, i.e. end year 0. And if we do so, the present value of the residual value is 0.64 * 3200 =2050
So, this residual value adds up to the value of the enterprise, based on the cash flows during the forecasting period, i.e. 870: the total value of the enterprise (or: firm value) is then 2920. Note that this is the enterprise value, the economical value of fixed assets and net working capital. From this, we can calculate the economic value of equity by applying:
(Economic) value of equity = Enterprise value + Cash – Debt = 2920 + 20 – 1080 = 1860
Note that this was based on an assumed WACC of 16%. That this is not a fully correct approach will be explained later. For now, we will make some additional remarks on the remainder period.
Remarks on the remainder period
As written, the fact that the free cash flows in the remainder period will continue infinitely in the future is not probable. But it is also unlikely that there will be no structural increase of future free cash flows in the longer term. For example, as a consequence of price developments or economic growth.
Furthermore, one could assume a growth larger than the economic growth. However, by definition, this cannot be the case. Because this growth would be the result of events behind our planning horizon, beyond our field of view. Besides, at the end, this company would then supersede all competitors and obtain a monopoly in all markets. This is not a likely event. Therefore this can never be argued with success.
Besides, it is of course questionable whether such growth is a consequence of the company’s intrinsic position at the time of valuation. Or whether this is a result of the new investments or efforts of the new management after the moment of valuation.
This also affects the eternal discussion between the buyer and seller of a company. According to the seller, future growth is an intrinsic (ingrained) value of the company. A consequence of the facts and circumstances at the time of valuation. The buyer has to pay for this.
But the buyer often reasons completely different. The future growth of the company (and the related growth of the free cash flows) is a result of his own efforts. He will certainly not pay the price for that!
In short, the cash flows during the remainder period must be carefully motivated. And only based on these motivations an acceptable valuation outcome can be achieved.
WACC
The core of the Discounted Cash Flow method is the calculation the net present value of all future cash flows during the forecasting period and remainder period. This is done with the use of the Weighted Average Cost of Capital (WACC). This discounting process is necessary because of the time value of money: today’s € is more valuable than the future one. And let us now have a closer look at this WACC!
On the debit side of the balance sheet we can find the assets of the company. They generate the cash flows. These are fixed assets and net working capital. But also intangible assets, patents, know-how, commercial network. So goodwill in general. These assets are financed by the capital components: equity and debt. Note that we have credited current liabilities, like creditors, accrued expenses, notes payable, et cetera as a part of the net working capital.
Now the formula for the WACC is relatively simple:
WACC = Req * Equity / (Equity + Debt) + Rd * (1- f) * Debt / (Equity + Debt).
Wherein
- Equity: share capital plus retained earnings;
- Debt: interest-bearing debt;
- f: Profit tax rate;
- Req: Cost of equity or required rate of return on share capital;
- Rd: Cost of interest-bearing debt, i.e. interest rate;
With this WACC we will discount all future cash flows to the present value. The total of all net present values represents the economical enterprise. Note that this is not the economical value of the equity (the shares). For this we have to add to the outcome the unbound cash (or cash-like items) and subtract from the outcome the interest-bearing debt (or debt-like items).
So far the process seems to be simple and straightforward. But there are several complications that make the Discounted Cash flow method difficult in a computational sense. And this because of the following reasons:
At first, the Equity and (interest-bearing) Debt must be taken at the market value. We cannot use the book values, which can be found in the accounting reports. That is definitely a challenge.
Secondly, the cost of equity Req has to be based on fixed risk-free premiums plus premiums for investing in ‘shares’ plus a premium for investing in small companies (small firm premium) plus various company-specific surcharges. But, what is risk and what surcharges must be taken into account? We will also come back to this further.
Thirdly, the Req, determined according to the previous remark, may not be applied in the formula of the WACC. Because this particular Req assumes that no debt was contributed to the funding. This particular Req is so-called unlevered. If the company is co-financed with borrowed capital (i.e. debt), then this will imply an additional risk for the shareholders. The Req leveraged is therefore higher. And only that higher leveraged Req (Reql) may be used. We will also explain this later.
All in all, this means that the determination of the WACC is an iterative and therefore a complex process. And besides, a recalculation should take place every year during the forecasting period. In fact, this should be done per incremental indivisible time interval. That we do not do that in practice seems understandable!
Determining the unlevered cost base equity
The Requ is the unlevered rate of return on share capital, i.e. in the absence of any debt. This Requ is an addition of a number of risk premiums.
In formula Requ = Rf + Rm + Rs + Ru.
Wherein
- Rf: risk-free interest rate, for example the interest-rate 10-year governmental bonds. These are bonds of high quality. At moment approximately 0.3% (2018);
- Rm: the market premium for investing in shares. This is a premium for risk that most of the companies encounter, like the risk of a recession or an increase in interest rates. This risk cannot be avoided by investing in a highly diversified portfolio. This market risk premium is constantly under research by many institutes. See for example www.market-risk-premia.com. This premium is currently around 5.5%;
- Rs: the Small Firm Risk premium. This is the extra risk for investing in SME companies in stead of companies whose shares are traded on stock markets. For SMEs, an average risk premium of 2% applies here. For the Medium sized companies, a smaller Rs can be argued, compared to the Small sized companies. This, however, requires careful considerations;
- Ru: the risk premium for a specific company;
Some organisations developed standard models for determining company-specific risk premiums. As a result, a number of fundamental adjustments were made to the model that determined the small firm premium Rs. Various academic studies show that the required return on an investment in companies is higher as the company is smaller. To compensate for the increased risk for smaller companies, investors require a higher return on their shares. This extra premium is sometimes referred to as the small firm premium (SFP). This SFP corresponds to the aforementioned Rs. For these Rs we take a fixed percentage of 2%, as indicated above.
Company specific risk factors Ru
BDO Corporate Finance researched company specific risk factors. Seven factors are indicated as significant. These factors together contribute to the risk premium that applies specifically to a particular company: Ru.
Determinative for Ru are:
- Dependence on customers: companies that have few customers or are dependent on a few very large customers carry extra risks;
- Supplier dependency: if a company depends on a product or service that is offered by only a limited number of suppliers, there is also a risk here;
- Dependency on management: one or more persons have often maintained contacts with staff, customers and suppliers for many years. Should this person fall out, there is a real chance that the continuity of the company will be in danger;
- Track record: it is important that the trend that future cash flows show can be derived from and based upon historical cash flows: the ‘track record’. If a company shows very volatile cash flows or high yields are promised while this is not realistic, given the history of the company, then this implies a potential risk;
- Diversity of activities: there is a risk in the case of a minimal diversity of activities. When the company’s markets deteriorate, the company may get into trouble;
- Entry barriers: high entry barriers impede entry to the market. So, this reduces the risk that margins will diminish;
- Flexibility: Flexible companies are able to quickly react to external changes. For example, reduce production in times of stagnations and to increase in a recovering market. This increases the extent to which a company can respond to market changes;
Research has led to certain weighting factors for the seven characteristics: the score factor is a number between 0 and 1. A 1 implies that a company is sensitive to this risk, a 0 means that this company is insensitive to this risk. If a company has a high-risk score on all characteristics, then a maximum Ru of 9.2% can be achieved.
From Requ to Reql
As already mentioned, the cost of equity is in proportion to the volume of debt. That appears to be weird, but can be made understandable. The providers of debt capital generally receive a lower return on their capital invested. They will therefore -in compensation for this lower return – accept lower risk. So, they will require security and a privileged position.
For the providers of equity (share capital), i.e. the shareholders, this means that they will probably end up with nothing in the case of a financial debacle. And certainly the more that risk-avoiding providers of debt have provided substantial amounts of capital. So, debt has an inflating effect on the required rate of return on shares.
For example with an Requ of 18% and an Rd of 4% and a ratio of Debt / Equity = 25%, the Reql is 18% + 3.5% = 21.5%. So the required rate of return on equity for the levered firm is 3.5% higher.
Where are we now?
Just an intermediate step: where are we now? We have calculated the free cash flows, based on well-founded expectations. This applies both for the forecasting period and the remainder period. And based on good knowledge and understanding of the company: the assets and the intangible values (knowledge, network organization, image, etc.).
Also, we master the formula for the WACC. We also determined the Requ. And we know that we must make the translation from the unlevered Requ to the levered Reql. This is important, because we can only apply this levered Reql in the WACC formula.
At this point, let us go back to the Discounted Cash Flow method for valuing the company of Brian. Let’s assume the following. The Requ has been determined at the level of 16.0%. The interest rate Rd is 6%.
By using a WACC of 16%, we calculated the economic value of BriWiFra’s shares to be 1860. This looks a bit reasonable. Because the book value of equity is 1160. And using a multiple of six times the net profit in year 0, we end up with 2077. So our estimation of 1860 seems to be a bit in between! So, let us assume that the equity value of 1860 is approximately right.
The market value of the loan capital is 1080. So, the Reql is a higher. It can be found by applying
Reql = Requ + (Requ – Rd) * Debt/Equity.
This results in a Reql of 21.8%. And when putting this Reql in the WACC formula, gives a WACC of 15.45 %.
Apparently, we have calculated the economic value with a too conservative (high) WACC = 16%. Therefore we recalculate the economic value with this new WACC = 15.45%. And this ends up with an economic enterprise value of 3030, which is a bit higher than the 2920 as was calculated with the WACC of 16%.
Formally, we must again recalculate the WACC, because the economic value of the enterprise has changed. And with that the economic value of equity, i.e. 3030 minus 1080 (debt) plus 20 (cash) is 1970. If we do so, we will calculate a WACC of 15.47%, resulting in an enterprise value of 3025. So, in practice the improvement as a consequence of the second iteration is nil. And probably less significant than probable deviations due to false predictions of future cash flows or false estimations of risks.
Based on this, the enterprise value is calculated to be 3025. The economic value of equity is then 3025 minus debt plus cash is 3025 + 20 – 1080 = 1965. The book value of the equity, shareholders capital plus retained earnings, is 1160. Apparently there is a surplus, i.e. 805. This can be denoted as goodwill: the additional value due to it’s capacity to generate cash flows.
Limited remaining period
Up till now, Brian feels comfortable with the outcome: a positive goodwill of 805. This comfortable feeling continues till William pops up. William presents himself as a potential buyer of the company BriWiFra.
After extensive discussions with Brian, William understands and agrees with the forecasted cash flows and the company specific risk assessments. But he thinks that an infinite remaining period is not realistic. The residual value must be based on a annuity, i.e. in time restricted and fixed period. And not based on a perpetuity like Brians’ valuation expert assumed.
Williams view on BriWiFras’ business is that hardwood will be legally restricted after a while. New synthetic alternatives will substitute the hardwood window frames. A remainder period, restricted to 5 years (after forecast period), seems to be more realistic. So, based on that he calculates a residual enterprise value of 1100. So, the total enterprise value, including the value due to the cash flows during the forecast period, is then 1980. The economic value of equity is then only 920.
And this is quite a shock to Brian. Because this is 240 less than the book value. Apparently, William estimates that BriWiFra performs worse than is should. Merely due to its long-term perspectives.
Improving the value drivers
This appraisal outcome is not so nice for Brian. He must quickly take proper actions. He should improve the value drivers of his business.
A first step that Brian can take is to improve the cash management. Currently, debtors pay on average after 1.4 months. The stock remains in progress for 4.3 months. That needs improvements! As a result of stricter agreements with customers, simple improvements in debtor management and material planning, Brian is able to reduce accounts payables by 25% and the inventory by 45%.
This gives BriWiFra an initial cash inflow of 550. That immediately adds to the value of his shares. In addition, Brian improves the risk profile of his company. He develops a new product line in a response to future legislation regarding the use of hardwood. His Requ drops from 16% to 14.5%. All with all, the value of the shares of the company BriWiFra increases to 2050. A real quick win!
And so, Brian now knows for sure: improving the value drivers is worthwhile!
Epilogue on the Discounted Cash Flow method
This article provides the most important backgrounds and explanations of the Discounted Cash Flow method. It is clear that a lot of calculation is involved. Applying the Discounted Cash Flow method certainly requires some knowledge and experience in arithmetic. But this arithmetic is not the most important challenge. The greatest challenge is the substantiation of the underlying starting points.
These determine the credibility of the outcome. And in discussions between buyers and sellers of companies about value, the discussion focuses on the perception of the potential of the assets to generate free cash flows in the (uncertain) future. Related to this: the great significance of valuation with the Discounted Cash Flow method is not primarily the outcome. But it is in the process of creating that result: the common understanding of the cash flow generating capacity of a company (or a project).
In addition, it should be noted that value is not the same as price. Due to various circumstances (demand / supply, timing, negotiation skills, emotion, transactions costs, transparency of markets), pricing will often differ substantially.
Valuation according to the Discounted Cash Flow method provides early valuable insight into the position and potential of the company in the process of a business sale or succession. And above all: the Discounted Cash Flow method also provides insight into how enterprise value can be improved. Especially by improving the risk profile, cash management and profitability.
When this is implemented, the company is optimally prepared for a business sale. So, in the exploratory phase of business sale, the Discounted Cash Flow method already proves its great value.