So you have heard a lot of market jargon that will last you a lifetime.
The bad news is that you will listen to more of it as new words, acronyms, and phrases are minted and make their way into financial literature.
Some will make sense, and others not so much. However, and I can guarantee you this, once you hear the phrase “DCF valuation model,” you will be left in a sense of wonder and awe.
What is it? What is it used for?
How is it used for what it is used for?
The positives? The negatives?
Well, I am here to help.
This post is for anyone who wants to understand DCF and not be left awestruck the next time they hear someone say this on TV or at a social gathering.
Better yet, by the time I am done with this, I hope some of you will be confident enough to throw this phrase around and sound like a finance guru.
Ready? Good. Let’s go.
1. What is DCF?
DCF stands for discounted cash flow. This valuation technique is built on the sound theory that a $ of cash flow today is dearer than a $ of cash flow in the future.
Go back to when you were a child and your uncle from out of town came visiting and offered you a choice because he didn’t bring the duty-free box of chocolate you crave.
Take a $1 bill today or wait for him to visit the next time and get you two boxes of chocolate.
You will weigh more than what you can get today than you may get in the future. So, your choice is to grab on to that $ bill.
Your response here is guided by the certainty of the present and the uncertainty of the future. After all, no one knows when the uncle will visit again, and there is no guarantee that he will remember to bring one box of chocolate, let alone two, the next time he does come.
Also, maybe I wouldn’t like chocolates the next time he comes because I am entering my teens and want to get busy building that Six Pack?
Whatever the reason, we have a logical & rational framework to work with here. Cash flow today is dearer than cash flow in the future.
2. What Is The Discount in DCF?
The beauty of finance is that there is no room for philosophy unless it can be mathematically articulated. The Lordships of Finance (early academics) debated on how to model discounted cash flow for years. The prevailing theory, after much deliberation, centered around the notion of opportunity cost.
I have $ today that I can invest and get $1.1 a year later. Whether this is a good deal would depend on what else I can do with the $ today.
Say I can invest it elsewhere and get $1.2 a year later. Naturally, I will frame the first opportunity in the context of the second. In this case, the next best opportunity available has a higher potential rate of return and I will not invest in the first.
To speak academically, the discount factor is the required rate of return from the investment being appraised. This could be the general market return, the risk-free rate, the risk-free rate plus some equity premium, or any other appropriate benchmark. It will vary based on the situation.
3. What can DCF be used to value?
DCF has many real-world applications in the sphere of valuation. These include but are not limited to:
- Project Appraisal
- Company Valuation
- Investment Appraisal
- Real Estate Valuation
- Lease Vs Buy Decisions
- Restructuring & Distressed Debt Valuation
4. DCF – Select Example – Investment Appraisal
4.1. Investment Appraisal
Let us assume that an analyst is presented with the following metrics
- Current Share Price – $50 per share
- Last Year’s Dividend – $5 per share
- Growth Rate in Dividend – 12% per annum
- Average Stock Market Index Fund Return – 10%
Presented with the above, the analyst is asked to undertake a DCF-based valuation to evaluate the investment for a 5 year holding period with the stock price at $80 per share.
Notes:
- The initial investment is shown as an outflow, hence the negative parentheses;
- The dividend is cash inflow and is increased each year by 12% – the growth rate;
- The discount factor is calculated using the formula 1/(1+r)^n, where r is the 10% stock market index fund return and n is the period (Year 1 = 1; Year 2 = 2 etc);
- The NPV stands for Net Present Value and is a summation of the discounted cash flows from Year 0 to Year 5;
- If the NPV is positive, the investment is recommended. Had it been negative, the investment decision would have been to refuse the opportunity. Logically, the investor would be better off investing in the total stock market index fund instead.
4.2. Company Valuation
The same concept may be applied to Company Valuation as well. Here, let’s assume that we are presented with the following information:
- Current Share Price – $50 per share
- Last Year’s Dividend – $5 per share
- Growth Rate in Dividend – 3% per annum
- Average Stock Market Index Fund Return – 10%
- Total Number of Shares – 1,000,000
- Current Market Capitalization – $50,000,000
To value a company, we will use the Gordon Growth Model (also called the Dividend Discount Model), a variation of DCF.
This is represented by the equation = P0 = D0*(1+g) / (r-g)
Where:
- P0 = Price Today
- D0= Last Year’s Dividend
- g= Growth Rate
- r = Required Rate of Return
Punching our numbers in;
- P0 = $5(1+0.03) / (0.10-0.03)
- P0= $73.57
As can be inferred, the fair value of this share is $75.57, and it is currently undervalued.
The Company valuation would be $75,570,000 (Share Price * Outstanding Number of Shares).
5. Critical Analysis of DCF as a Valuation Technique
5.1. Advantages
- Detailed analysis & capable of incorporating the most granular details;
- Allows generating valuations and decisions independent of comparable in the market;
- Allows one to run the sensitivity of key factors (GDP growth, exchange rates, inflation, etc) and measure how they impact valuation.
5.2. Disadvantages
- Assumes cash flows to occur at the end of the period, which is not the case, as cash flows may be recurring. Even in the case of dividends, a company may announce up to 4 dividends in a calendar year and can announce special dividends on top of that;
- Projections of cash flows, growth rates & discount factors to use are only estimates which may or may not materialize. Hence, extreme care must be taken to avoid the “garbage in; garbage out” problem;
Conclusion
As you can see, DCF is a powerful tool for valuation purposes. Personally, what I like about this method as compared to others is the logic underpinning it.
Yes, there are quite a few drawbacks and this method is not a definitive model by any means.
It is precisely for this reason that analysts rely on multiple valuation models in practice, and then compare and take averages as best estimates. That being said, if you’re looking for detail, this is the best option out there.
Good luck showing off your newly acquired knowledge on the topic.
If you have any questions or want to know more, send me your query to the FinChamps channel, and I will be more than obliged to help.
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