Discounted cash flow (DCF) Analysis: Tutorials

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment. DCF attempts to find out the value of an investment today, based on the cash flows that will generate in the future. DCF can be used to value financial investments for investors as well as for business owners looking to make investments, such as funding an expansion or purchasing new equipment.

Several variations of DCF model exist but the most common model is the Two-Stage DCF model. In this variation, the free cash flows are forecasted for five (or even 10 years) (the first stage), and then a terminal value is calculated to account for all the cash flows beyond the forecasted period (second stage).

This method is generally not used for small companies or non-mature firms because the requirement for using this model is that the company should have positive and predictable free cash flows.

• To calculate the discounted cash flow (DCF), present value of future cash flows is calculated using a discount rate.
• If the discounted cash flow (DCF) is greater than the current cost of investment, the opportunity will most likely result in positive returns.
• Most companies use the weighted average cost of capital (WACC) as the discount rate, as it takes into consideration the rate of return expected by shareholders.
• The downside of DCF is that it relies on estimations of future cash flows, which could be inaccurate.

The equity (share) markets represent all companies that the public own shares in. The markets discount the impact on a company’s cashflow of all economic and company-specific information. This gives you the share price. One way to do this is the two-stage discounted cashflow.

Academic Questions, Examples

Academic Questions, examples on this topic.

Question:

Hier Mobile Ltd. has acquired the licence to manufacture mobile phones from the Sagem catalogue. The new phones will have some modern features that did not exist when the original phones were made but it will NOT have Smartphone capability. The phone has been designed to attract the first generation mobile phone users and is expected to be 90% cheaper than an IPhone. The company expects to generate £3,000,000 of free cash flow, that is expected grow at 30% a year for 3 years and 1.5% thereafter. The company’s cost of capital is 12%.

• a) What is the value of Hier Mobile Ltd.?
• b) Outline the risks for potential investors in Hier Mobile Ltd.

In these practice questions you were given the growth rates 30% a year for 3 years and 1.5% thereafter. In your assignment YOU have to forecast the growth rates for the first five years… You also have to CALCULATE the discount rate and divide the value by the number of outstanding shares of your chosen company. YOU then compare this with the ACTUAL share price to decide whether the share is worth more (BUY) or less (SELL).

Another Example

• Year: 2020, 2021, 2022, 2023, 2024, 2025
• Levered FCF $ millions: -2.4b, -455m, 2.3b, 4.4b, 6.3b
• Present Value: -2,200, -387, 1,700, 3,100, 4,200, 5,100
• Growth Rate: 20 times, 4 times, 7 times, Estimate +47%, Estimate +33.9%, Estimate +24.5%

Consider the above information, the present value of the 10-year cash flow gives a total of $37.3b with a terminal value of $272 billion compared to the present value of $119.9 billion.

But as mentioned, several intrinsic factors come into play with investments.

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