Discounted Cash Flow (DCF) method in 4 steps [+example].

The Discounted Cash Flow (DCF) method determines the value of a business by estimating future free cash flows and discounting them at a discount rate (the WACC) that reflects the business’s risk profile. The higher the risk, the higher the discount rate, and the lower the resulting enterprise value. After the EBITDA multiple, the DCF method is the most commonly used valuation method in business acquisitions.

Content:

1. What is the Discounted Cash Flow (DCF) Method?
2. How does the DCF method work in 4 steps?
3. What are the advantages of the DCF method?

1. What is the Discounted Cash Flow method?

In a business acquisition, it is important for both the buyer and the seller to know the value of the business in question. To arrive at a well-founded business valuation, both parties often use the DCF method. The Discounted Cash Flow method, often abbreviated as DCF, is a method for valuing businesses and is the second most commonly used method after the EBITDA multiple method. These methods are often used in conjunction with each other to arrive at a more accurate estimate of the business’s value.

The key premise of the DCF method is that the past plays only a limited role; the focus is primarily on a business’s future earning capacity. To do this, a calculation is made of the expected future cash flows, which are then discounted (converted to present value) at a certain rate.

To determine that discount factor, we look at the specific characteristics of the business in question, also called value drivers. You can think of:

• The extent to which the business depends on its owner.
• The predictability of revenue.
• Presence of a strong management team
• Distribution of revenue across customers
• Innovativeness of the business
• Market entry barriers

A risk profile is established based on the value drivers mentioned above. The higher the risk for the buyer, the higher their required rate of return will be. And a higher required rate of return translates into a higher discount rate and, consequently, a lower enterprise value.

2. How does the DCF method work in 4 steps?

To arrive at a business valuation based on the DCF method, the following four steps are followed:

1. Analyze the past
2. Forecast future cash flows
3. Determine the discount rate
4. Determine the company value

Step #1: Analyzing the Past

Even though the DCF method looks to the future, the analysis begins with a look at the past. To predict the future, it is necessary to determine where the business's strengths lie. Consider the following questions:

• What is the future earning power based on?
• Does the business have a distinctive product?
• Does it have exclusive deals with large customers or suppliers?
• Does it produce cheaper than the competition?
• Is the business more innovative than its industry peers?

Every company has its own unique mix of distinguishing and value-determining factors. To paint as realistic a picture as possible of the company’s past performance, the financial statements are normalized. This means they are adjusted for one-time or non-market-conforming items. Examples include a controlling shareholder with a management fee that exceeds a typical executive salary, or one-time consulting fees related to a business transfer.

These are examples of cost items that unfairly depress the bottom line and thus give an inaccurate picture of earning power. Balance sheet items will also be looked at in this way. Are there hidden reserves that depress equity? Are there debt relationships with shareholders that need to be repaid? Correcting all such items will produce normalized financial statements, which will serve as the basis for further calculations.

Step #2: Forecast future cash flows.

Now that the past has been mapped out, we can determine the future cash flows. Of course, this is not a matter of simply extrapolating the historical data. A business is always evolving and therefore future cash flows will look different than in the past.

The basis for determining the future cash flow is the business plan. Market expectations and strategic choices made all affect cash flows. Think about investments in new or machinery to be replaced, entering a new market or divesting a business activity.

You incorporate all the implications of the business strategy and market developments into a cash flow statement for the next three to five years. For each year, incoming cash flows are offset against outgoing cash flows, excluding financing costs and dividend payments. This makes it clear how much “free cash flow” remains to repay loans, pay interest, and reward shareholders for their efforts. It is common practice to develop three scenarios: a worst-case, a best-case, and a normal-case scenario.

Step #3: Determining the discount rate

Once the future cash flows are set up, then you calculate the net present value of these based on the WACC; the Weighted Average Cost of Capital. This is a discount rate based on a weighted average of both the return requirement on equity and the cost of debt.

You weight both assets in proportion to their share in total assets. You express the WACC as a percentage. The higher the WACC, the higher the return requirement and the cost of debt capital, the lower the value of the company.

The one component of the WACC, the cost of debt capital, is easy to determine. In the case of a bank loan, it is the interest rate charged by the bank. However, the required return on equity is less straightforward to determine because it is based on the risk profile of the business. After all, the higher the risk, the higher the required return.

How do you determine the required return on equity?

When determining the return requirement, the return on government bonds is often taken as a starting point. This return is assumed to always be achievable with an investment. Let's set this at 3%. Investing in listed equities is a lot riskier and therefore requires a higher return. Historical figures show that in the long run a return of 8% is realistic. The risk premium of equities over bonds is therefore 5%.

Investing in an individual business - because that's what a buyer ends up doing - is much riskier than investing in publicly traded shares. The mere fact that the shares of a limited liability company are not freely tradable leads to higher risk. An additional risk premium of 7% for investing in a BV compared to listed shares is quite defensible. This brings the minimum required return on equity to 15%.

But then we are not there yet. Every business and every industry has its own risks. At the company level, for example, it is the dependence on the owner, the quality of the management, the innovativeness or the spread of activities. At the industry level, it is, for example, entry barriers, upcoming laws and regulations or the opportunities and threats of the Internet.

All these factors can justify a risk premium or discount and thus a higher or lower return requirement, respectively. Percentages between 15 and 25 are common. Private equity parties often even charge a return requirement on equity of 30%.

Calculation Example of a WACC (Discount Rate)

From the determination of the company's risk profile comes a return requirement on equity of 20%. The equity to debt ratio is 65/35 and the business has taken out a bank loan at 5.5%. The corporate tax rate is 25%.

The calculation of the WACC is as follows:

(20% × 65%) + (5.5% × (1 – 0.25) × 35%) = 13% + 1.4% = 14.4%

Step #4: Determine the enterprise value

Now that the future free cash flows and the discount rate have been determined, we can plug these figures into the Discounted Cash Flow formula. You discount each future free cash flow using the WACC, and then add the discounted residual value (the cash flow after the forecast period) to that:

Enterprise Value = Σ [free cash flow in year n / (1 + WACC)^{^n}] + terminal value / (1 + WACC)^{^n}

Suppose the WACC is 14.4% and we have a four-year forecast period, during which we have determined the free cash flows as follows: 200,000, 75,000, 300,000, and 225,000 euros. The period following the forecast years (in this case, four) is called the residual period. The cash flow during this residual period is assumed to be constant; in this example, we set it at 150,000 euros per year. Calculated step by step:

As mentioned, in practice, three scenarios are often set up. The DCF calculation can be applied to each of these scenarios. In principle, the worst case scenario will yield the lowest business valuation, because here the free cash flows are the lowest. However, the probability of achieving this scenario is a lot higher than the best case scenario. Hence, the bad case scenario has a lower risk profile and therefore a lower return requirement on equity. This in turn has an upward effect on the value.

3. What are the advantages of the DCF method?

The DCF method not only gives insight into the value, but also shows how the value of the company is affected. This can be done by turning two knobs: ensure that the earning capacity increases and thus the future cash flows, or ensure that you lower the risk profile and thus the discount rate. In addition, the DCF method offers several distinct advantages:

• It assumes the future situation and only that is relevant for a buyer
• The method is based on cash flows and not on (manipulable) profit figures.
• For buyers, a DCF calculation is valuable because banks attach great importance to future cash flows when granting loans

The main advantage is that a DCF report enables a meaningful discussion about a company’s value. The buyer and seller can engage in a dialogue: Why are sales estimated at one million euros next year, when they were seven hundred thousand last year? Are there contracts underlying those figures? Why are costs expected to drop by 10% in the coming years? If the value is determined based on a rule of thumb, such as “five times net income,” such a substantive discussion isn’t possible. Then it quickly turns into horse-trading.

Frequently Asked Questions About the DCF Method

What is the Discounted Cash Flow method, in a nutshell?

The DCF method determines a business’s value by estimating future free cash flows and discounting them using the WACC. The higher the business’s risk profile, the higher the WACC, and the lower the final valuation will be. It is the most commonly used valuation method after the EBITDA multiple.

What are the 4 steps involved in a DCF valuation?

First, you analyze the past and normalize the financial statements; then, you forecast future free cash flows for three to five years; next, you determine the discount rate (WACC) based on the risk profile, and finally calculate the enterprise value by discounting the cash flows and the terminal value.

What is WACC and how do you calculate it?

The WACC (Weighted Average Cost of Capital) is a weighted average of the required return on equity and the cost of debt, proportional to their share of total capital. In the example calculation with a 20% required rate of return, an equity-to-debt ratio of 65/35, and a bank loan at 5.5% (after taxes), the WACC comes out to 14.4%.

Why does the DCF method yield a different result than a rule of thumb such as 5 times net income?

A rule of thumb uses a fixed, historical earnings figure, while the DCF method is based on several years of future free cash flows, each of which is discounted separately at a risk-weighted discount rate. As a result, the DCF method takes growth, declining costs, or investments into account more effectively than a fixed multiple.

What are the advantages of the DCF method compared to other valuation methods?

The DCF method looks to the future rather than the past, uses cash flows that are less susceptible to manipulation than profit figures, and provides a basis for substantive discussion between buyer and seller—rather than the “horse-trading” that often arises when relying on a rule of thumb.

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