Guide to Discounting Cash Flows
Discounting Cash Flows: The value of a company is equal to the value of future cash flowsCash Flow StatementA Cash Flow Statement (officially called the Statement of Cash Flows) contains information on how much cash a company has generated and used during a given period. It contains 3 sections: cash from operations, cash from investing and cash from financing. generated by the company’s operations, discounted at the required rate of returnRate of ReturnThe Rate of Return (ROR) is the gain or loss of an investment over a period of time copmared to the initial cost of the investment expressed as a percentage. This guide teaches the most common formulas for calculating different types of rates of returns including total return, annualized return, ROI, ROA, ROE, IRR 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 BookInvestment Banking ManualCFI's Investment Banking book is free, available for anyone to download as a PDF. Read about accounting, valuation, financial modeling, Excel, and all skills required to be an investment banking analyst. This manual is 466 pages of detailed instruction every new hire at a bank needs to know to succeed.
Building a discounted cash flow modelWalk me through a DCFThe question, walk me Through a DCF analysis is common in investment banking interviews. Learn how to ace the question with CFI's detailed answer guide. Build a 5-year forecast of unlevered free cash flow, calculate a terminal value, and discount all those cash flows to present value using WACC. 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 perpetuityPerpetuityA perpetuity is a cash flow payment which continues indefinitely. An example of a perpetuity is the UK’s government bond called a Consol. Although the total value of a perpetuity is infinite, it has a limited present value using a discount rate. Learn the formula and follow examples in this guide 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 capitalCost of CapitalCost of capital is the minimum rate of return that a business must earn before generating value. Before a business can turn a profit, it must at least generate sufficient income to cover the cost of the capital it uses to fund its operations. Cost of capital consists of both the cost of debt and the cost of equity, 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 forcesIndustry AnalysisIndustry analysis is a market assessment tool used by businesses and analysts to understand the complexity of an industry. There are three commonly used and
- Value chain analysis
- Product lifecycle
Additional Resources
Thank you for reading this section of CFI’s free investment banking bookInvestment Banking ManualCFI's Investment Banking book is free, available for anyone to download as a PDF. Read about accounting, valuation, financial modeling, Excel, and all skills required to be an investment banking analyst. This manual is 466 pages of detailed instruction every new hire at a bank needs to know to succeed on discounting cash flows. To keep learning and advancing your career, the following additional CFI resources will be helpful:
- Estimating Free Cash flow for Valuation PurposesIB Manual – Estimating Free Cash FlowEstimating free cash flow is used in valuation because it is the best measure of a firm's value. Earnings can be manipulated and in the end, “cash is fact – profit is an opinion”. Key drivers of Free Cash Flows are: sales growth rates, EBITDA margins, cash tax rates, fixed capital investment, working capital
- Discounted Cash Flow DCF FormulaDiscounted Cash Flow DCF FormulaThe discounted cash flow DCF formula is the sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period #. This article breaks down the DCF formula into simple terms with examples and a video of the calculation. The formula is used to determine the value of a business
- DCF Terminal Value FormulaDCF Terminal Value FormulaTerminal value formula is used to calculate the value a business beyond the forecast period in DCF analysis. It's a major part of a financial model as it makes up a large percentage of the total value of a business. There are two approaches to calculate terminal value: (1) perpetual growth, and (2) exit multiple
- Business Life CycleBusiness Life CycleThe business life cycle is the progression of a business and its phases over time, and is most commonly divided into five stages: launch, growth, shake-out, maturity, and decline. The cycle is shown on a graph with the horizontal axis as time, and the vertical axis as dollars or various financial metrics.
