Valuation using discounted cash flows

+ExampleMedICT is a medical ICT startup that has just finished its business plan. Its goal is to provide medical professionals with bookkeeping software. Its only investor is required to wait for five years before making an exit. Therefore, MedICT is using a forecast period of 5 years. The forward discount rates for each year have been chosen based on the increasing maturity of the company. Only operational cash flows (i. e. free cash flow to firm) have been used to determine the estimated yearly cash flow, which is assumed to occur at the end of each year (which is unrealistic especially for the year 1 cash flow; see comments aside). Figures are in $thousands: Cash flows Year 1 Year 2 Year 3 Year 4 Year 5 Revenues +30 +100 +160 +330 +460 Personnel −30 −80 −110 −160 −200 Car Lease −6 −12 −12 −18 −18 Marketing −10 −10 −10 −25 −30 IT −20 −20 −20 −25 −30 Total 36 22 +8 +102 +182 Risk Group Seeking Money Early Startup Late Start Up Mature Forward Discount Rate 60% 40% 30% 25% 20% Discount Factor 0.625 0.446 0.343 0.275 0.229Discounted Cash Flow(22)(10)32842This gives a total value of 41 for the first five years' cash flows. MedICT has chosen the perpetuity growth model to calculate the value of cash flows beyond the forecast period. They estimate that they will grow at about 6% for the rest of these years (this is extremely prudent given that they grew by 78% in year 5), and they assume a forward discount rate of 15% for beyond year 5. The terminal value is hence:
(182*1.06 / (0.15–0.06)) × 0.229 = 491. (Given that this is far bigger than the value for the first 5 years, it is suggested that the initial forecast period of 5 years is not long enough, and more time will be required for the company to reach maturity; although see discussion in article.) MedICT does not have any debt so all that is required is to add together the present value of the explicitly forecast cash flows (41) and the continuing value (491), giving an equity value of $532,000. Valuation using discounted cash flows (DCF valuation) is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach". Discounted cash flow valuation was used in industry as early as the 1700s or 1800s; it was explicated by John Burr Williams in his The Theory of Investment Value in 1938; it was widely discussed in financial economics in the 1960s; and became widely used in U. S. courts in the 1980s and 1990s. This article details the mechanics of the valuation, via a worked example;
it also discusses modifications typical for startups, private equity and venture capital, corporate finance "projects", and mergers and acquisitions,
and for sector specific valuations in financial services and mining. See Discounted cash flow for further discussion, and for context.

The diagram aside shows an overview of the process of company valuation. All steps are explained in detail below.

The initial step is to decide the forecast period, i. e. the time period for which the individual yearly cash flows input to the DCF formula will be explicitly modeled. Cash flows after the forecast period are represented by a single number; see § Determine the continuing value below. The forecast period must be chosen to be appropriate to the company's strategy, its market, or industry; substantial costs are often incurred at the start of the first year – and with certainty – and these should then be modelled separately from other cash flows, and not discounted at all. (See comment in example.) Forecasted ongoing costs, and capital requirements, can be proxied on a similar company, or industry averages; analogous to the "common sized" approach mentioned; often these are based on management's assumptions re COGS, payroll, and other expenses. the free cash flow is the amount of cash available to be paid out to all investors in the company after the necessary investments under the business plan being valued. Synergies or strategic opportunities will often be dealt with either by probability weighting / haircutting these, or by separating these into their own DCF valuation where a higher discount rate reflects their uncertainty. Tax will receive very close attention. Often each business line will be valued separately in a sum of the parts analysis. When valuing financial services firms, FCFE or dividends are typically modeled, as opposed to FCFF. This is because, often, capital expenditures, working capital and debt are not clearly defined for these corporates ("debt is more akin to raw material than to a source of capital" (Loan covenants in place will similarly impact corporate finance and M&A models.) Alternate approaches within DCF valuation will more directly consider economic profit, and the definitions of "cashflow" will differ correspondingly; the best known is EVA. With the cost of capital correctly and correspondingly adjusted, the valuation should yield the same result, for standard cases. These approaches may be considered more appropriate for firms with negative free cash flow several years out, but which are expected to generate positive cash flow thereafter. Further, these may be less sensitive to terminal value

The continuing, or "terminal" value, is the estimated value of all cash flows after the forecast period. Typically the approach is to calculate this value using a "perpetuity growth model", essentially returning the value of the future cash flows via a geometric series. Key here is the treatment of the long term growth rate, and correspondingly, the forecast period number of years assumed for the company to arrive at this mature stage; see and The alternative, exit multiple approach, (implicitly) assumes that the business will be sold at the end of the projection period at some multiple of its final explicitly forecast cash flow: see Valuation using multiples. This is often the approach taken for venture capital valuations, where an exit transaction is explicitly planned. Whichever approach, the terminal value is then discounted by the factor corresponding to the final explicit date. Note that this step carries more risk than the previous: being more distant in time, and effectively summarizing the company's future, there is (significantly) more uncertainty as compared to the explicit forecast period; and yet, potentially (often Its implied exit multiple can then act as a check, or "triangulation", on the perpetuity derived number. (i. e. as to opposed to listed mining corporates) the forecast period is the same as the "life of mine" – i. e. the DCF model will explicitly forecast all cashflows due to mining the reserve (including the expenses due to mine closure)
– and a continuing value is therefore not part of the valuation.