What is DCF analysis?

What-Is-DCF-Analysis-and-How-Can-It-Help-Value-a-Company-1024x726
Blog / Financial Literacy

What is DCF analysis?

How can this method contribute to the evaluation of a company?

DCF analysis is a valuation method based on estimating the current value of future cash flows. Considers the risk and growth potential of the investment to determine an accurate valuation. By using this method, you can compare companies or investments and make better decisions.

How does the Discounted Cash-Flow (DCF) or Discounted Cash Flow Process work?

The purpose of DCF analysis is to calculate the value of an investment after adjusting for the time value of money.

The time value of money assumes that a euro today is more valuable than a euro tomorrow, because this euro can be invested today. DCF analysis is useful in analyzing an investment that will produce cash flows in the future.

DCF analysis involves several assumptions:

 – Understanding a company’s discounted cash flow: Discounted cash flow is a company’s estimated future cash flow adjusted for risk associated with its investment.

 – Finding its terminal value: Terminal value estimates the future performance of a company beyond the explicit period.

 – Creating an exit multiple: The exit multiple is a factor used to determine how much an investor should pay for the company, or investment, with based on your expected performance.

Pros and cons of DCF analysis:

Pros:

 – Intrinsic Valuation: Because the DCF method is based on company-specific fundamentals, the implied valuation is determined by projecting projected free cash flows ( FCFs) of the company and the cost of capital (i.e. discount rate). DCF’s accuracy on future financial performance is considered academically rigorous. The underlying valuation factors are objectively modeled, be they assumptions related to revenue growth, operating margins and free cash flows, making the DCF-derived valuation more sustained and more resilient in a future earnings discussion.</p >

 – Market independence: DCF analysis is market independent. The current trading price does not affect the final valuation. The market may be incorrect in pricing a company. DCF is not affected by temporary market distortions and mispricing of securities. Another advantage of the DCF approach is that the valuation is autonomous and does not depend on similar transactions.

Cons:

 – Sensitivity of DCF to assumptions: The main disadvantage of the DCF approach is its dependence on assumptions, since small changes to critical assumptions can significantly affect the assessment. As each assumption significantly impacts the company’s valuation, the accuracy of the valuation is dependent on financial projections. This type of projection is more difficult to make when we are dealing with a company with recent activity.

 – Capital structure is fixed: One of the disadvantages of the DCF approach is that the company’s capital structure is assumed to be constant. Companies tend to increase their dependence on debt financing as they gradually mature. However, always taking this assumption into account in a DCF may be impractical, especially since increased debt dependence is not a given. Although an adjusted capital structure can be assumed in a DCF model based on the D/CP ratios of comparable mature companies.

Conclusion:

It is important to understand that the DCF valuation methodology is not a new concept and is globally accepted.

If you are an investor, DCF analysis can help you make better investment decisions based on accurate information. This method allows you to accurately evaluate companies and increase your chances of achieving financial success!

Good luck!

Carry out a free simulation of your business now to find out how much your company is worth: