Following the launch of our DCF model and LBO model, we are providing an overview of how to build a Discounted Cash Flow (DCF) model which is an essential valuation method used in M&A, Private Equity, and Investment Banking.
DCF analysis breaks down into three key components: income, costs, and timing. Private equity firms and investment bankers rely on this method to assess a company’s intrinsic value, calculate Free Cash Flows (FCF), and discount them to present value to determine whether a deal is financially viable.
FCFs are typically discounted using the Weighted Average Cost of Capital (WACC) to calculate Net Present Value (NPV) — a critical step in pricing acquisitions, leveraged buyouts (LBOs), and M&A transactions.
This guide simplifies the process, covering financial data collection, sensitivity analysis, and key assumptions — ensuring your financial modelling skills align with industry standards in investment banking and private equity.
A DCF model involves forecasting a company’s free cash flows and then discounting them to present value using the company’s weighted average cost of capital (WACC). This will result in the expected price to be paid for the firm, asset or portfolio.
Historical Financial Statements: Income statement, balance sheet and cash flow statement for at least the past 3 to 5 years.
Free Cash Flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. FCF is crucial as it reflects the company’s ability to generate cash from operations, which can be used to expand, pay dividends, reduce debt, or other purposes.
FCF = Net Income + Non-Cash Charges (Depreciation & Amortization) – Change in Working Capital − Capital Expenditures
Cost of Equity: Use the Capital Asset Pricing Model (CAPM).
Cost of Debt: Average interest rate on the company’s debt, adjusted for tax benefits.
WACC Formula:
WACC=[𝐸/(𝐷+E)]×𝑅𝑒+ [𝐷/(𝐷+E)] 𝑅𝑑×(1−𝑇𝑐)
where 𝐸 is the market value of equity, 𝐷 is the market value of debt, 𝑅𝑒 is the cost of equity, 𝑅𝑑 is the cost of debt, and 𝑇𝑐 is the corporate tax rate.
Discount each projected free cash flow back to its present value using the WACC.
𝑃𝑉=𝐹𝐶𝐹(1+𝑊𝐴𝐶𝐶)^(-𝑡)
where 𝑡 is the year in the projection period.
Terminal value represents the value of a company’s cash flows beyond the projection period, reflecting the bulk of a DCF valuation. There are two primary methods to calculate terminal value:
Gordon Growth Model:
𝑇𝑉=𝐹𝐶𝐹𝑛+1(𝑊𝐴𝐶𝐶−𝑔)
where 𝐹𝐶𝐹𝑛+1 is the free cash flow in the first year after the projection period and 𝑔 is the perpetual growth rate. This model is sensitive to the growth rate which means that even a small reduction of the growth rate can significantly impact the valuation due to decreasing the denominator.
Exit Multiple Method: Apply an industry-standard exit multiple to the final year’s projected financial metric (e.g EBITDA or EBIT).
Sum the present value of projected FCFs and the discounted terminal value.
𝐸𝑉=∑(𝐹𝐶𝐹𝑡(1+𝑊𝐴𝐶𝐶)𝑡)+𝑇𝑉(1+𝑊𝐴𝐶𝐶)𝑛
This step consolidates the present value of all future cash flows, providing a comprehensive measure of the company’s total value.
Subtract net debt (total debt minus cash) from the enterprise value to get the equity value.
𝐸𝑞𝑢𝑖𝑡𝑦 𝑉𝑎𝑙𝑢𝑒=𝐸𝑉−𝑁𝑒𝑡𝐷𝑒𝑏𝑡
Equity value represents the residual value available to shareholders after satisfying all obligations.
Perform sensitivity analysis by varying key assumptions (e.g. WACC, growth rates) to understand their impact on valuation. This analysis helps assess the robustness of your model and identify critical value drivers. You can sensitize metrics such as the IRR (Internal Rate of Return) or MOIC (Multiple of Invested Capital) to understand the impact of changes in variables in the expected profitability.
A well-constructed DCF model offers a detailed and insightful analysis of a company’s intrinsic value by projecting its future cash flows and discounting them to present value. It is crucial to use realistic assumptions, validate your model against industry benchmarks, and cross-check with other valuation methods to ensure accuracy.
Sensitivity analysis helps identify critical assumptions and their impact, enhancing the robustness of your valuation. Ultimately, a comprehensive DCF model serves as a vital tool for investors and analysts to make informed financial decisions, providing a clearer picture of a company’s financial potential and guiding strategic investment choices.
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