What is a discounted cash flow model?
A discounted cash flow model (DCF model) is a model to look at discounted cash flows of a firm.
How does it work?
- Project out financial statements, including Free Cash Flow
- Typically, we forecast out 5 years then assume a Terminal Value
- Discount Free Cash Flow and the terminal value using an appropriate discount rate
Walk Me Through a DCF (Interview Question)
This is a very common interview question that comes up in corporate finance interviews.
- Project out financial statements, typically for 5 years
- Calculate terminal value using Gordon Growth Model or an exit multiple
- Discount back to time 0 using an appropriate discount rate, such as WACC for FCFF
DCF Assumptions and Frequently Asked Questions
Discount Rate to Use
The discount rate used depends on what type of Free Cash Flow we’re discounting. If we’re discounting Free Cash Flow to Firm (FCFF), then we use the Weighted Average Cost of Capital. If we’re discounting Free Cash Flow to Equity (FCFE), then we use the cost of equity as the discount rate.
How many years do we project out?
The key here is to project for as many years as we can have reliable projections UNTIL the cash flows stabilize. Typically 5 years is used because for most firms it’s hard to project accurately beyond 5 years. For reference, keep in mind that most equity analysts, whose main job is to forecast the company’s performance, doesn’t get the next quarter perfectly accurate.
If the cash flows going into the future will continue to be the same, you don’t need to forecast out every year because the information is repetitive. For example, for a royalty property that will generate $1 million a year in perpetuity in free cash flow, you don’t need to project out anything. You just take the present value of the perpetuity and it’s done because every year’s free cash flow is the exact same.
Enterprise Value or Equity Value?
If we’re discounting Free Cash Flow to Firm (FCFF) with the weighted average cost of capital, then we end up with Enterprise Value. If we’re discounting Free Cash Flow to Equity (FCFE) with the cost of equity, then we end up with Equity Value.
Enterprise Value = Equity Value + Net Debt + Minority Interest Equity Value = Enterprise Value – Net Debt – Minority Interest (simple algebra)