Valuation using discounted cash flows

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.

Cash flows after the forecast period are represented by a single number; see § Determine the continuing value below.

The forecast period must be chosen to be appropriate to the company's strategy, its market, or industry;[2] theoretically corresponding to the time for the company's (excess) return to "converge" to that of its industry, with constant, long term growth applying to the continuing value thereafter; although, regardless, 5–10 years is common in practice[2] (see Sustainable growth rate § From a financial perspective for discussion of the economic argument here).

Typically, this forecast will be constructed using historical internal accounting and sales data, in addition to external industry data and economic indicators (for these latter, outside of large institutions, typically relying on published surveys and industry reports).

Future costs, fixed and variable, and investment in PPE (see, here, owner earnings) with corresponding capital requirements, can then be estimated as a function of sales via "common-sized analysis".

Approaches to identifying which assumptions are most impactful on the value – and thus need the most attention – and to model "calibration" are discussed below (the process is then somewhat iterative).

There are several context dependent modifications: Alternate approaches within DCF valuation will more directly consider economic profit, and the definitions of "cashflow" will differ correspondingly; the best known is EVA.

With the cost of capital correctly and correspondingly adjusted, the valuation should yield the same result,[10] for standard cases.

A fundamental element of the valuation is to determine the appropriate required rate of return, as based on the risk level associated with the company and its market.

[11][3][12] In its early stages, where the business is more likely to fail, a higher return is demanded in compensation; when mature, an approach similar to the preceding may be applied.

(Some analysts may instead account for this uncertainty by adjusting the cash flows directly: using certainty equivalents; or applying (subjective) "haircuts" to the forecast numbers, a "penalized present value"; or via probability-weighting these as in rNPV.)

[5] M&A analysts likewise apply the first approach, with risk as well as the target capital structure informing the cost of equity and, thus, WACC.

To account for this, a "mid-year adjustment" is applied via the discount rate (and not to the forecast itself), affecting the required averaging.

[14] For companies with strong seasonality — e.g.: retailers and holiday sales; agribusiness with fluctuations in working capital linked to production; Oil and gas companies with weather related demand — further adjustments may be required; see:[15] The continuing, or "terminal" value, is the estimated value of all cash flows after the forecast period.

Whichever approach, the terminal value is then discounted by the factor corresponding to the final explicit date.

Note that this step carries more risk than the previous: being more distant in time, and effectively summarizing the company's future, there is (significantly) more uncertainty as compared to the explicit forecast period; and yet, potentially (often[6]) this result contributes a significant proportion of the total value.

Here, a very high proportion may suggest a flaw in the valuation (as commented in the example); but at the same time may, in fact, reflect how investors make money from equity investments – i.e. predominantly from capital gains or price appreciation.

A related approach is to "reverse engineer" the stock price; i.e. to "figure out how much cash flow the company would be expected to make to generate its current valuation... [then] depending on the plausibility of the cash flows, decide whether the stock is worth its going price.

NPV is typically the primary selection criterion between these; although other investment measures considered, as visible from the DCF model itself, include ROI, IRR and payback period.