Why Discount Future Cash Flows?

Before we get into the specifics of how to value a business with the DCF method, we will briefly look at the theory behind discounting cash flows.

The concept of discounted cash flows relates to what someone would be willing to pay today to receive cash flows in the future.

The basic idea is that the sooner someone will receive a future payment, and the more certain they are of receiving it, the more valuable it is today. Money you have today is worth more than an identical amount to be received in the future. Additionally, the risk associated with the possibility of not receiving those future cash flows also makes them worth less today.

We call money that we would receive in the future the future value, and the money we would receive today the present value.

When we do a DCF analysis of a business, we’re looking at the business as an asset that will produce future cash flows. We want to discount the expected future cash flows back to their net present value to think about what it would be worth paying in today’s dollars for those future cash flows.

Three major considerations behind discounting cash flows are the opportunity, risk, and inflation. First, we invest present dollars in order to receive future cash flows because we perceive the opportunity to earn a return on our investment. We also need to take into account the risk of not receiving the future payments. Additionally, we need to consider how inflation affects our money—money today will buy more than the same amount will in the future.

With a discounted cash flow valuation, we are discounting the value of the future expected cash flows we will receive in the future back to their net present value today. The net present value of the business’ expected future cash flows is the enterprise value of the business.

Understanding Discounted Cash Flow Valuation:

Discounted cash flow valuation is one of the best methods of valuing a private company.

Private company valuation is both an art and a science and there are several different methods that are commonly used to value a business in addition to the discounted cash flow method.

Normally, the goal with a valuation is not to come up with a single, exact number that the business is worth—but instead to use several different valuation methods (like DCF) to come up with a range of values that might make sense to pay for the business. Once this range of values has been determined, negotiations can begin with the intention of making a deal. For more on how private company valuation works, we recommend our guide: Intro To Private Company Valuation as a companion to this guide.

With the DCF method of valuation, we’re looking at the business’ expected future cash flows and we are discounting them back to their present value. In other words, we’re looking to see what it’s worth paying today, for a stream of expected cashflows to be received in the future.

Here is the formula for how discounted cash flow valuations are calculated:

• CF₁ — The cash flow for period 1
• CF₂ — The cash flow for period 2
• CF₃ — The cash flow for period 3
• CF₄ — The cash flow for period 4
• CF₅ — The cash flow for period 5‍
• r — The discount rate
• g — The perpetual growth rate

Here, we’re looking at the cashflow for the period (year, quarter, etc.) divided by one plus the discount rate, to the power of the period we’re looking at.

As mentioned above, there are several different methods commonly used to value private companies. From the perspective of the DCF valuation method, we’re looking at this business as an asset that will generate these future cash flows. Our objective here is to total up all of these cash flows and discount them back in time to see their present value. This present value tells us what these future cash flows are worth today. The value of the business depends on the value and the timing of the expected cash flows.

When done correctly, the DCF method of valuation gives us the enterprise value of the business.

Enterprise value is the total value of the business, without giving consideration to its capital structure. This takes into account all capital providers—both debt and equity. Normally, enterprise value is compared to the equity value of the business—the value that shareholders would receive if the company was sold.

You can learn more about the difference in our guide: Enterprise Value Vs Equity Value. In that guide, we use the example of two residential houses, both worth $250,000. The first house is owned through a mortgage with $50,000 equity and $200,000 owed on a mortgage. The second house is owned outright with no mortgage.

In the case of both houses, the enterprise value is the same—$250,000. The equity values are different. The first house has $50,000 in equity and the second house has $250,000 in equity.

The distinction to remember is that enterprise value is the total value of the business, not what shareholders would be paid out in a sale (equity value).

Here is how to calculate the equity value of a business:

1. First, do a DCF valuation of the business to arrive at its enterprise value.
2. Next, calculate net debt by totaling up all of the debt the business has and subtracting the value of any cash it has.
3. Finally, subtract the net debt from the enterprise value to arrive at the equity value.

Factors That Influence Discounted Cash Flow Valuation:

Now that we understand what the discounted cash flow method of valuation is and how it is calculated, we’ll look at the factors that influence a DCF model.

There are three major mistakes people make with DCF valuations:

1. They use the wrong cash flows.
2. They use the wrong discount rates.
3. They don’t account for the timing of those cash flows.

Here, we will address these mistakes and look at the factors that influence a discounted cash flow valuation.

When we’re valuing a business with the DCF method, we are attempting to take the expected future cashflows for the business and discount them backwards in time to their present value—what they are worth paying for today.

To do this, it’s important that we use the right cash flows and the right discount rate.

Previously, we looked at the concept of enterprise value and saw that enterprise value gives us the total value of the business without giving consideration to the business’ capital structure. In order to use the right cash flows, we need to take into account the cash flows receivable by all capital providers (debt & equity investors), and we need to discount them back at a rate that also accounts for all capital providers.

In this diagram, we would want to use the unlevered free cash flows in the numerator, and we would want to use the WACC in the denominator (r). This gives us consistency between the numerator and the denominator by accounting for all capital providers in both. To learn more about how DCF models account for all capital providers, we recommend our guides: Unlevered Free Cash Flows and Weighted Average Cost of Capital.

Using the DCF formula with the unlevered free cash flow and the weighted average cost of capital will give us our enterprise value. From there, we can figure out the equity value by subtracting net debt from the enterprise value.

Forecast Period & Terminal Value in DCF Valuations:

The third biggest mistake people make when doing DCF analysis is they don’t account for the timing of the cash flows. There are two keys to understanding the timing of the cash flows.

1. Understanding that the cash flows could be received at the beginning, middle, or the end of the period and taking this into consideration.
2. Looking at the business as a going concern—and accounting for cash flows indefinitely into the future.

First, to understand the timing of these cash flows, we need to understand the period we’re discounting cash flows in. Common periods are months, quarters, and years. Cash flows could be received at the beginning, middle, or at the end of these periods. If the cash flows are not received at the beginning of the period, they are expressed as percentages of the period. It’s important to take this into consideration when doing DCF valuations because in reality, the timing may not align perfectly between when those cash flows are received and when we are creating our forecast.

As we’ve seen so far, our DCF model is broken into two parts. First, we have our initial forecast period. Here, we assume that the business will grow faster than it will grow later on down the road. We will break these periods (often years) out in more detail than in later years.

The terminal value of the business accounts for all of the future expected cash flows the business will produce indefinitely into the future, after this initial forecast period. In other words, it is the value of all of the free cash flow beyond that forecast period. Here, we assume the business is a going concern, meaning that it could theoretically operate indefinitely into the future, but also account for how the sale of the business could impact the valuation.

Often, terminal value is calculated with both the growing perpetuity method and the exit multiple method and they are compared side by side in a DCF valuation. You can learn more about terminal value in our guide: Terminal Value & Forecasting In DCF Models.

What Does A DCF Valuation Tell Us?

Previously we looked at how a DCF valuation gives us the enterprise value of the business. We also saw how we can calculate the equity value of the business from there.

But how does this actually help us in the decision-making process?

Basically, if you pay less than the discounted cash flow valuation for the business, your return would be higher than the discount rate. Conversely, if you paid more than the DCF valuation, you would make a return lower than the discount.

To make sense of this, we need to look at our required rate of return—our target for what we determine we need to make as a return on this investment. We can compare our required rate of return to what our return on the business would be to think about how this investment makes sense or why it may not.

Recommended Resources:

• Intro To Private Company Valuation
• Unlevered Free Cash Flows
• Weighted Average Cost Of Capital
• Enterprise vs Equity Value