What is DCF, How to calculate DCF and What are the pros and cons of DCF,

What Is DCF?

A DCF model is a specific type of financial modeling tool and technique used to value a business or company. DCF stands for Discounted Cash Flow. DCF model is simply a forecast of a company unlevered free cash flow discounted back to present value which is used to evaluate the potential for investment, which is called the Net Present Value (NPV).DCF Valuation estimates the intrinsic value of an asset/business based upon its fundamentals.

How To Calculate DCF?

- First model out the future earnings of the company, ideally with the help of management estimates, broker estimates, maybe some third party figures, and our own judgments.

- After the forecast find the Free Cash Flow to Firm (FCFF) in each year: + EBIT - Tax on EBIT - Capex + Depreciation + Amortization - Increase in WC assets + Increase in WC liabilities + Any other cash or non-cash adjustments that are company specific = FCFF

- For the terminal value, at the end of the forecast period:

(1) The Gordon Growth Model: (Final Year FCFF * (1 + Perpetual Growth Rate) ) / (WACC - Perpetual Growth Rate)

(2) Exit Multiple, which could be based on the entry multiple, or the long term average multiple for the industry, depending on the situation

- Then discount the FCFFs to the present value Terminal Value with the annual free cash flow in the final forecast year o FCFF in a particular year / (1+ WACC) ^ number of years in the future that particular cash flow occurs

- This would give you the Enterprise Value

o To get the equity value: + Enterprise Value - Minority Interests - Net Debt - Unfunded Pension Liabilities - Preferred Shares + Associates / JVs = equity value

What Are The Pros and Cons Of DCF?

Pros-

In theory, it is the most sound method of valuing a company because It uses specific numbers that include important assumptions about a business, including cash flow projections, growth rate, and other measures to arrive at a value.

Less influenced by market conditions because It does not require market value comparisons to similar companies.

It shows the intrinsic valuation of company based on the company model and operations.

DCF allows to consider long terms value because it assess earnings of a project or investment over its entire economic life and considers the time value of money.

DCF analysis is suitable for analyzing mergers and acquisitions because it helps company judge whether a company should merge with or acquire another company.

Cons-

Discounted cash flow analysis requires a significant amount of financial data, including projections for cash flow and capital expenditure over several years. Some investors might find it is difficult to gather the needed data and even simple processes take some time.

DCF can be easily manipulated by growth rates and discount rates.

No one can accurately predict future Free Cash Flow in DCF.

Does not work with all companies like tech startups early in the business cycle.

DCF is not subject to market fluctuation it is depend on analyst assumption.

DCF often produces the most variable output since it is dependent on future assumptions.