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Concept
Valuation using discounted cash flows
Summary
Valuation using discounted cash flows (DCF valuation) is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money.
The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period.
In several contexts, DCF valuation is referred to as the "income approach".
Discounted cash flow valuation was used in industry as early as the 1700s or 1800s; it was explicated by John Burr Williams in his The Theory of Investment Value in 1938; it was widely discussed in financial economics in the 1960s; and became widely used in U.S. courts in the 1980s and 1990s.
This article details the mechanics of the valuation, via a worked example;
it also discusses modifications typical for startups, private equity and venture capital, corporate finance "projects", and mergers and acquisitions,
and for sector-specific valuations in financial services and mining.
See Discounted cash flow for further discussion, and for context.
Value of firm =
where
FCFF is the free cash flow to the firm (essentially operating cash flow minus capital expenditures) as reduced for tax
WACC is the weighted average cost of capital, combining the cost of equity and the after-tax cost of debt
t is the time period
n is the number of time periods to "maturity" or exit
g is the sustainable growth rate at that point
In general, "Value of firm" represents the firm's enterprise value (i.e. its market value as distinct from market price); for corporate finance valuations, this represents the project's net present value or NPV.
The second term represents the continuing value of future cash flows beyond the forecasting term; here applying a "perpetuity growth model".
Note that for valuing equity, as opposed to "the firm", free cash flow to equity (FCFE) or dividends are modeled, and these are discounted at the cost of equity instead of WACC which incorporates the cost of debt.
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