DCF VALUATION TEMPLATE
DISCOUNTED CASH FLOW VALUATION MODEL
This Discounted Cash Flow technique involves deriving the value of a business by calculating the present value of its expected future cash flows. Projected cash flows, inferred from the Business Plan, are used for the five years ahead while the Terminal Value is adopted for the remaining foreseeable future.
In this sense, the value of the company is the sum of the enterprise value, calculated on the 5 years cash flow, and the residual amount of its terminal value. Both these values are discounted in order to equalise their value to today’s real value: the future value of money is indeed less than the same amount of money today.
The DCF model calculates the present value of the business future cash flows. In the template model that you can download here, you will have to insert your own parameters in order to reflect the conditions of your own company.
Obviously you will have to include your forecasts for the future, but also some specific financial indicators. In particular, you will have to determine:
- Terminal Growth Rate
- Market Risk Premium
- Risk-Free Rate
Or directly the WACC
TERMINAL GROWTH RATE
The terminal growth rate is used to understand how much will the company grow after the 5 years forecasted in the cash flows. It’s a perpetual growth and it’s supposed to reflect the growth of the company once it matured into a stable entity that has stopped growing exponentially or even significantly.
The reason behind this assumption is that the company will grow forever, therefore it is expected to grow together with the market. Generally, the terminal growth rate takes a value between the forecasted inflation and the expected GDP growth. It’s important to underline that, on a mathematical level, if any entity grows more than the GDP of its market it will eventually become bigger than the market itself, creating a logical paradox.
The Weighted Average Cost of Capital is the cost that a business is expected to pay for the acquisition of the capital it needs to operate. In particular, this value is weighted against two sources of capital: equity and debt.
Both equity and debt have a cost that is inherent to the nature of the capital itself. Debt will reflect the cost of financing, while equity the cost that the investors expect to receive from their investment. In this sense, WACC could be seen ad the opportunity cost of making an investment in a business.
The cost of capital and debt are averaged based on the weight of each component: the final cost reflects the composition of the capital (equity + debt) and their respective costs.
If calculating the cost of the debt side of the equation is relatively straightforward, the equity sees more terms coming into play. In particular Market Risk Premium, Risk-Free Rate, and Beta.
MARKET RISK PREMIUM & RISK-FREE RATE
Investors expect to be compensated for the risk they are taking by investing in your company and the time value of money.
In this sense, the risk-free rate accounts for the time value of money and generally equals the rate of return that they could get from investing in very safe investments (normally 15 years state bonds offer a good reference for this value).
The other components of the equation is the additional risk that the investors are taking, and therefore the market premium they are expecting to have back from the investment.
Beta is a coefficient used to describes the relationship between systematic risk and expected return for a specific asset. It represents how likely the stocks of a company, or the business itself, are going to distance themselves from the overall market.
In general, a beta under the value of 1.0 indicates that the company’s performance is less volatile than the market and therefore more resilient to crisis and market’s swings. If beta is over 1.0 instead, the company is more volatile and both riskier and potentially more rewarding.