Guide to Discounting Cash Flows
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 will only invest in a company if it offers a return greater than the risk-free rate of return. This guide to discounting cash flows outlines 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, therefore, prone to error. To try to mitigate some of the issues with forecasting, a DCF model is based on a two-step approach. The first step covers the visible forecast cash flow period and the second step covers a continuing period beyond that.
Discounting Cash Flows – The Two-Step Approach to DCF Valuation
The two-step approach starts with forecasting 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 limit the forecast period, as the longer the period, the more prone to error the forecast is. After this initial period, the remaining value 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 growth 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 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 that the business is booming – growing rapidly. However, the generation of returns in excess of the cost of capital usually attracts competition. That eventuality has the effect of forcing returns back nearer the cost of capital. The CAP establishes the time over which cash flows need to be estimated before relying on terminal value. To estimate the 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 CFI resources will be helpful: