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Discounted Cash Flow (DCF) Valuation

Basis and Categorization

Discounted Cash Flow (DCF) valuation is a fundamental approach that estimates the value of an asset based on the present value of its expected future cash flows.

1. Basis for DCF Valuation:

  • Core Principle: The value of an asset is equal to the sum of all future cash flows it is expected to generate, discounted back to their present value.
  • Free Cash Flow (FCF): The cash flow available to the company's investors (both debt and equity holders) after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed assets have been made. This is the foundation of DCF.
    • FCF to Firm (FCFF): Represents the cash flow available to all investors (debt and equity). This is used when valuing the entire company (enterprise valuation).
    • FCF to Equity (FCFE): Represents the cash flow available only to equity holders after all debt obligations have been met. This is used when valuing the equity portion of the company.
  • Discount Rate: The rate used to discount future cash flows to their present value. It reflects the riskiness of the cash flows and the required rate of return for investors.
    • Weighted Average Cost of Capital (WACC): The average rate of return required by all investors in the company (both debt and equity). Used when discounting FCFF. WACC takes into account the relative proportions of debt and equity in the company's capital structure and the cost of each.
    • Cost of Equity (Ke): The rate of return required by equity holders. Used when discounting FCFE. Several models can be used to estimate the cost of equity (e.g., Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), build-up methods).
  • Terminal Value (TV): The value of the company or asset beyond the explicit forecast period. Since it's impossible to forecast cash flows forever, TV represents the present value of all cash flows beyond the forecast horizon.
    • Growth in Perpetuity: Assumes that the company will grow at a constant rate forever. TV = FCF_(n+1) / (r - g), where FCF_(n+1) is the cash flow in the year after the forecast period, r is the discount rate, and g is the constant growth rate.
    • Exit Multiple: Assumes that the company will be sold at a multiple of its earnings, revenue, or book value at the end of the forecast period. TV = Multiple * Financial Metric.

2. Categorization of DCF Models:

DCF models can be categorized based on several factors, including:

  • Type of Cash Flow:
    • Free Cash Flow to Firm (FCFF) Model: Values the entire company (enterprise value) by discounting FCFF at the WACC. Equity value is then derived by subtracting the value of debt from the enterprise value.
    • Free Cash Flow to Equity (FCFE) Model: Values the equity directly by discounting FCFE at the cost of equity (Ke).
  • Forecast Horizon:
    • Two-Stage Model: A shorter explicit forecast period (e.g., 5-10 years) followed by a terminal value calculation.
    • Multi-Stage Model: A longer explicit forecast period with multiple stages of growth (e.g., high growth, transition, stable growth). Useful for companies with rapidly changing growth rates.
  • Growth Assumptions:
    • Constant Growth Model (Gordon Growth Model): Assumes a constant growth rate of cash flows forever. Simplest model, best suited for stable, mature companies.
    • Variable Growth Model: Allows for varying growth rates over the forecast period. More realistic for most companies.
  • Adjustments for Complexity
    • Dividend Discount Model (DDM): A specific application of DCF used to value stocks based on the present value of their expected future dividends. Best suited for companies with a history of paying dividends and predictable dividend policies.

The choice of DCF model depends on the specific characteristics of the company being valued and the availability of data. In general, more complex models are appropriate for companies with more volatile or unpredictable cash flows, while simpler models are suitable for stable, mature companies.

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