All about DCF (Discounted cash flow method)
Let’s understand what DCF (Discounted Cash Flow) method of valuation in a simple and detailed manner is, so its easy to understand even if you are not from a finance background.
What is DCF (Discounted Cash flow Method)?
DCF method is a valuation method which we and valuation companies use to estimate the value of an investment or a company based on the money it is expected to generate in the future.
In other words, discounted cash flow method of valuation, where we forecast future cash flows and discount them to present value to find the intrinsic value of a business. It’s one of the most widely used methods in real-world Finance.
Intrinsic value of a business –
Intrinsic value means the true, real, and natural worth of a business, based on its fundamentals (not just the current market price). Seedhi Bhasha me bole to - How much is this business really worth if we look at its ability to make money in the future?”
Understood let’s move forward.
Why DCF method of valuation is Important?
· This method shows the true value of business and investment.
· If any investor wants to invest in any company’s stock then by this method, he/she can identify that the stock is undervalued or overvalued.
· In DCF valuation all the calculations are based on numbers and assumptions and on reliable data, it is not guessing work or hypothesis work. The valuation price is very reliable.
Why Does DCF Matter?
· DCF model helps investors to save overpaying premium
· The valuation calculated by DCF method tell the really worth of company.
· This is most convenient method to identify in long-term investment decisions, mergers, acquisitions, and project evaluations.
What are the uses of DCF?
· It is useful to check stock is real price.
· It helps to decide whether to invest in a new project or not.
· It is used to evaluate if buying another company is worth it or not (M&A deals).
· It helps to make long-term strategic investment decisions.
What are the Important Steps of DCF?
Step 1 – Forecast future cashflows - Forecast how much money the company will generate in the next 5–10 years.
Step 2 – Calculate a discount rate – Calculate a weighted average cost of capital rate or we can say it required rate of return as per investor perspective. This rate replicates the time value of money and risk taken by investor by investing in equity and debt.
Step 3 - Convert to present value – convert the future cash flows to present value by discount rate.
Step 4 - Estimate terminal value - After 10 years, the company will still exist, so we calculate a lump-sum value for all future year’s cash flows beyond.
Step 5 – Adding present value and terminal value - Present value of 10 years cash flows + terminal value = Total company value.
Common Mistakes in DCF
· People assume the company will grow very fast for many years. However, every company follow a lifecycle.
· mistake or taken the wrong assumption to calculate wrong percentage (discount rate) to bring future cash flows to Present value.
· Putting too much weight on the value after 10 years (terminal value).
· DCF model calculation is very sensitive, a small Errors or change can do big Impact on the final valuation amount. Any small change (positive or negative) in growth rate or discount rate make a big impact on result.
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