Your Company Is Worth As Much As Somebody Else Is Willing to Pay For It

Discounted Cash-Flow Analysis

Discounted cash-flow analysis (DCF) is a method of estimating internal, the so-called intrinsic value of the firm. This method relies on calculating the value of the business as a sum of all future cash-flows the firm will generate discounted to their present value. It is based on the idea that cash in hand now is worth more than the same amount of money received later. So the present value of $100 that will be generated a year from now is worth less than having $100 in your pocket today. It is because of the time value of money. You can put your $100 in the bank today to earn interest so that in one year you will get your $100 back plus some accrued interest, providing there is positive interest rate on your deposit, which there usually is. Following the same logic $100 earned in one year will have a greater present value than $100 generated in three years from now.

The job of valuing the business using discounted valuation methods consists in projecting free cash-flows for the chosen forecast period, estimating the terminal value of the company after the forecast period and calculating their present values. Then, in order to determine the fair value of the company's equity you will need to calculate the sum of the present value of all projected future free cash-flows and the present value of the terminal value and, in case of using free cash-flows to firm (FCFF), you will need to deduct the current value of bank debt.

Fair Value of Equity = Present Value of All Projected FCFs + Present Value of the Terminal Value – Current Bank Debt

The DCF valuation model is a suitable tool for determining the intrinsic long-term value of the firm but since it is entirely based on projecting future cash-flows, it is also prone to potentially large deviation from the actual market value in times of fast changing economic outlook. This method is more suitable as a basis for strategic long-term investment decisions rather than for short-term stock investing. If used for stock market investing it should be always used in conjunction with other valuation metrics, such as market ratio analysis, to give you more comfort to buy the stock if it trades at a healthy discount to its fair value or draw a red flag if the trading premium seems too large.

For more detailed info on DCF analysis please read the following chapters:

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