Definition of the discounted cash flow method

This method estimates the company’s future capitalized value based on cash flow available after tax. 

A company’s value is often valued today by calculating the discounted cash flow (DCF). This method is not (just) based on the results achieved previously, but seeks to determine what return the investor can expect in the future. The cash flow available after tax is used as the basis, because a company is only worth what it might bring in in the future. The future cash flow is discounted. The actual value of the cash flow is then obtained. The capitalization rate used to determine the discount (devaluation) is calculated in a similar way to that of practitioners’ method and usually fluctuates between 10% and 20%.

Depending on expected income, the DCF method can provide values that are much too high for some companies, and which are not achievable on the market. This method is almost only suitable for well-established companies that have been generating steadily rising profits for some years.

Procedure to follow

  1. Draw up a detailed budget for the next few years. Given that investments in floating assets and fixed installations have a large influence on financial cash flow, this means choosing a duration for the plan that covers the whole investment cycle.
  2. As the future Free Cash Flow (FCF) can only be prudently estimated for a certain number of years of planning, it is necessary, beyond that period, to calculate what is known as a residual value (capitalized future income) instead of the FCF. This residual value – as a general rule, 50% of the estimated value of the company – is assessed by capitalizing a representative FCF.
  3. Each result is then discounted on the reference date fixed for valuation using the weighted interest rate for financing costs. By discounting in this way, all future returns are brought back to the reference date at the time of the valuation, in order to identify the actual value of those returns.
  4. The discounted actual values are then deducted from foreign capital, and assets not vital to the smooth running of the company are added. The actual value of equity capital (respectively, share value) is then obtained.

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Last modification 20.08.2018

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