By Victor Paquet (Mergersight Operations) and Carlo Lepoardi & Tommaso Arona (Boston University partners)
A Discounted Cash Flow analysis is one of the three most common valuation methods alongside the Public/Trading Comps and Past Transactions methods.
A DCF model’s purpose is to find the intrinsic valuation of a company or cash generating asset. Contrary to the Public Comps method which gives you a relative value, the DCF method provides an intrinsic value of the company which you can then compare to its market value to determine whether the target is under/overvalued.
It is based on the present value of both future cash flows and a terminal valuation. As such, a tech company such as a Fintech for instance might have unstable cash flows, making it difficult to accurately forecast future cash flows. Thus using a DCF might not be the best option.
Forecast the business’s financials from revenue down to unlevered free cash flow for a period of 5 to 10 years.
Then, two commonly used methods to value the business beyond the forecasted period and compute the terminal value are the perpetuity growth method and exit multiple method.
To account for the time value of money, discount all those cash flows and the terminal value to their present value using the company’s weighted average cost of capital (WACC) formula. The WACC formula takes into account the proportion and cost of debt and equity used to finance the company. Thus, adjusting for capital structure when discounting to arrive at a present intrinsic valuation of the business.
Sum up all the discounted CFs and terminal value to compute the enterprise value and subtract any debt and outstanding diluted shares to find the intrinsic price per share.
Terminal Value - two ways
Exit Multiple: you assumes the business will be sold and estimate the value by applying an industry average multiple to the Revenue or EBITDA value.
Perpetuity Growth: assumes that the final year’s growth rate continues indefinitely hence we use the GDP Growth rate (2-3%) reflecting average economic growth.
N.B: Important to note that the model relies on key assumptions regarding revenue growth, operating margins, discount rate, and terminal value.