Discounted Cash Flow | DCF Model Step by Step Guide

A Discounted Cash Flow (DCF) model is a valuation method used to estimate the current value of an asset today based on its future cash flows.

The first key step in creating a DCF model is forecasting free cash flows, typically for a five to ten year period.

The second step in a DCF model is calculating the Weighted Average Cost of Capital (WACC), which serves as the discount rate to bring future cash flows back to the present.

The final step in a DCF model is to calculate the enterprise value, equity value, and implied share price to arrive at a valuation.

Free cash flow is the cash available to both debt and equity holders after a business covers its operating expenses, capital expenditures, and other investments.

The Free Cash Flow formula includes Earnings Before Interest and Tax (EBIT) multiplied by (1 minus the tax rate), plus depreciation and amortization, minus capital expenditures (CapEx), and adjustments for non-cash working capital.

The Weighted Average Cost of Capital (WACC) measures a company's cost of financing, which can come from either debt or equity.

The cost of equity is typically calculated using the Capital Asset Pricing Model (CAPM) formula, which includes the risk-free rate, often represented by the 10-year US Treasury.

The formula for equity value is enterprise value minus debt plus cash, which is equivalent to enterprise value minus net debt.

Kenji states that free cash flows usually occur throughout the year, not just at year-end, requiring a mid-year adjustment (e.g., using 0.5 instead of 1) for more accurate discount factor calculations.

Kenji states that a DCF model is not always applicable for companies with negative free cash flows, such as startups or highly growing companies, as it would result in a nonsensical negative valuation, requiring other valuation methods.