Discounted Cash Flows Method

DCF-based valuation is a method of valuing a project, company, or asset (you will use all three in your comprehensive business analysis) using the concepts of the time value of money covered in detail in any introductory book on financial management.

All future cash flows are estimated and discounted to give their present values (PVs)—the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV) – or ‘discounted present value’ (DPV) which is taken as the value or price of the cash flows in question.

Thus, financial value of the company, project or asset is just the sum of free cash flows (in the classic model called ‘future cash flows’ or FV) discounted to the valuation date – typically the first date of some year (e.g. 2015). As these flows are split between creditors and shareholders, shareholders’ value of the company is equal to its financial value minus value of its long-term debt.

This formula makes complete sense – corporate asset, project and the whole company are only valuable to their owners if they make money (generate free cash flows). And the longer you have to wait for the cash flow, the less valuable it is for you.

This formula works fine for the finite – limited duration – projects. With the ‘going concern’ (perpetual) projects such as a business entity, ‘N’ is equal to infinity. In these cases, financial value is equal to the sum of discounted cash flows for a specific period (5 to 10 years) plus the so-called terminal value (sum to the infinity). The latter (it’s just math) equals FV_t+1 – in so-called ‘normal’ year, divided by WACC. This is called the ‘perpetuity growth model’.