What is Discounted Cash Flow (DCF) Financial Modeling?
Discounted Cash Flow (DCF) is a business valuation widely used in financial modeling. It has a meticulous approach and uses internal factors in the computation. DCF components include the free cash flows, discount rate, projected time, and terminal value, as discussed below.
Four Components of Discounted Cash Flow
1. Free Cash Flows
Levered and unlevered cash flows are used for business valuation. However, DCF valuation mainly uses the unlevered cash flow to determine the available cash flow to debt and equity holders.
Levered cash flow is determined after deducting financial obligations (loan repayments, interest). Unlevered cash flow is the cash flow before considering the financial obligations.
Identifying the future cash flows is based on past performance and management’s expectation of business future performance.
2. Discount Rate
Future cash flows are discounted back to present value using a discount rate. The discount rate determines the risk of future benefits.
The widely used discount rate is the Weighted Average Cost of Capital (WACC). WACC represents both debt and equity capital. You can also base the discount rate on similar-risk investments.
3. Projected Time
Financial modeling usually considers five to ten years projected years. It is to capture how the business will behave in the future. The further the projection into the future, the higher the discounted factor to capture higher risk.
4. Terminal Value
The terminal value is used to capture the future cash flows beyond the projected years. The most widely used to compute for terminal value is the Exit Multiple Approach. This method assumed that the business would be sold in the future. So, the terminal value is added at the end year of the projection.
How to Compute Discounted Cash Flow (DCF) in Excel?
Discounted cash flow is the sum of future cash flows discounted back to their present value. It is also known as Net Present Value.
Let’s illustrate below how DCF is computed in Excel. Given the example below, unlevered free cash flows in five years are $200, $250, $325, $350, and $400, respectively. Correspondingly, the terminal value is $1,200. The further into the future, the higher the discount rate and the lower the discounted value is. All future cash flows, including the terminal value, are discounted back to their present value, amounting to $1,740.
Discounted cash flow is one of the go-to models in financial modeling. It has a meticulous approach loved by investors, entrepreneurs, management consultants, and other financial practitioners.
When using an industry-specific financial model, discounted cash flow is only one of the financial metrics used. The Payback Period, Cash-on-Cash Yield, and Internal Rate of Return are some of the key metrics.
You can access here a free DCF Model Template for your financial modeling.
