Guide to Discounting Cash Flows
The value of a company is equal to the value of future cash flows generated by the company’s operations, discounted at the required rate of return demanded by investors. A company is only as valuable as the future economic benefits it can generate. Cash flows are discounted because investors would only invest in a company if it offers a return greater than a traditional risk-free rate. This guide to discounting cash flows will outline what you need to know as an investment banking analyst.
This guide is an excerpt from CFI’s Investment Banking Manual Book.
Building a discounted cash flow model is difficult because there is uncertainty. We do not know what the future business environment will look like and forecasts are error-prone. To try and mitigate some of these issues with forecasting, a DCF model is based on a two-step approach: a visible forecast cash flow period and a continuing period.
The Two-Stage Approach to DCF Valuation
The two-stage approach is to forecast the cash flows of a company over a finite period of time, usually between 5 and 10 years (forecast cash flow period). We try to minimize the forecast period, as larger periods are more prone to error. After the initial period of more detailed forecasting, the remaining value of the company is captured by a terminal value, using either perpetuity or a multiple (continuing period).
The argument for using the terminal value calculation to capture a company’s value past the visible forecast period is based on the premise that it will hit a stage of maturity. Beyond this point, cash inflow estimates will not see any major deviations. Terminal values help prevent major exaggerations in our cash flow projections.
The Competitive Advantage Period (CAP)
The Competitive Advantage Period (CAP) is when the company is expected to generate returns on incremental investments that are greater than the cost of capital, meaning the business is booming. However, the generation of returns in excess of the cost of capital will attract competition, forcing returns towards the cost of capital. The CAP will establish the time length over which cash flows need to be estimated before relying on terminal value. To estimate CAP, we use approaches such as:
- Porter’s 5 forces
- Value chain analysis
- Product lifecycle
Thank you for reading this section of CFI’s free investment banking book on discounting cash flows. To keep learning and advancing your career, the following additional resources will be helpful: