Discount Cash Flow (DCF) Explained

One method we employ for fair market value studies is the discounted cash flow analysis (DCF), a commonly accepted method for valuing companies. Using the principles of “time value of money,” the DCF applies a discounted rate to adjust the value of money to be earned in future years with a present day value. There are two primary components used in calculating the DCF.  The first is the “projected net cash flow.”  Calculation of this figure includes building a pro forma income statement (or statements) and projecting a company’s earnings for several years into the future (typically a five year pro forma).  From that income statement, the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is calculated for each year, which is then used to derive the “projected net cash flow” for each respective year.

The second key component is the “discount rate.” The discount rate is a variable that adjusts the value of the projected net cash flows over time. There are generally accepted discount rates to use, depending on the type of business subject to valuation, the riskiness of the investment, and the relative rate of return yielding from alternative investment opportunities.  For example, when valuing the projected net cash flows of a startup, a discount rate of 50% (or higher) may be used to account for the extreme risk of the investment.  When valuing the projected net cash flows of a steel mill with guaranteed contracts extending out 5 years, it may be appropriate to use a 10% discount rate due to the secured nature of the projected cash flows. More commonly, a discount rate of 25% to 35% is used for valuing a typical operating company.

Once set, the discount rate is used to adjust each year’s prospective net cash flows accordingly so that the cash flows in year 1 are more valuable than the cash flows in year 2. To illustrate this, using a discount rate of 30%, the first year’s cash flows would be valued at 70% of their total value (100% – 30%). The cash flows of year 2 would be valued at 49% of their total value, 70% of 70%. The cash flows of year 3 would be valued at 34% of their total value, 70% of 70% of 70%. And so on.

Finally, once the net cash flows have been adjusted using the appropriate discount for each year, the “future value” of each year’s cash flows is calculated to determine the present day valuation for the entity based on its “discounted cash flows.”