Video: Discounted Cashflow Model

Hello, welcome. We're going to be discussing the discounted cash flow model.  The discounted cash flow model is a valuation method used to estimate the  attractiveness of an investment opportunity. The discounted cash flow analysis  use future free cash flow projections and then discount discounts them back to  their present value, using a required annual rate to arrive at present value  estimates. A present value estimate is then used to evaluate the potential for  investment. If the value arrived at through discounted cash flow analysis is  higher than the current cost of the investment, the opportunity may, in fact, be a  good one the time value of money is the assumption that $1 today is worth more than $1 tomorrow. For example, assuming 5% annual interest, $1 in a savings  account will be worth $1.05 in a year. Due to the symmetric property, if A equals  B and B equals A, we must consider $1.05 a year from now to be worth $1  today, when it comes to assessing the future value of investments, it is common  to use the weighted average cost of capital as the discount rate. The firm's free  cash flow can be used to calculate the value of the firm and a discounted cash  flow model. This approach forecast the firm's future free cash flows, discounts  the cash flows using the firm's weighted average cost of capital and the equity  value equals the firm's assets minus the debt value. So first we need to forecast  the near term cash flows. Then we'll forecast the long term growth rate and the  terminal value. Discount the annual cash flows and terminal value to determine  the present value of the firm inputs to the discounted cash flow model, forecast  the future cash flows, determine base or initial cash flow forecast near and long  term growth rates. Also we need to achieve the calculation of weighted average  cost of capital to give us our discount rate. So let's look at a discounted cash  flow example. So first we'll look at the equation so the discounted cash flow  equals cash flow one divided by one plus the rate of return, which will be our  weighted average cost of capital calculation, plus cash flow two divided by one  plus the rate. Now we're going to raise by two because it's the second period.  We'll continue this out until we receive no more cash flows, or we sell the  opportunity and move on to another one, right? We'll raise it to that value. Okay,  so obviously CF equals cash flow, okay, r equals our discount rate or our  weighted average cost of capital. Okay. So now for a hypothetical Company X,  we would apply the discounted cash flow analysis by first estimating the firm's  future cash flow growth. We would start by determining the company's trailing 12 month free cash flow equal to that period's operating cash flow minus capital  expenditures. Say that company X's current free cash flow is 50 million. We  would compare this figure to previous years cash flow. In order to estimate a  rate of growth. It is also important to consider the source of this growth are sales increasing, are costs declining. These factors will inform assessments of the  growth rate sustainability. So say that you estimate that company X's cash flow  will grow by 10% in the first year, so cash flow will increase 2% okay in the first  two years, year one and two, okay. Then cash flows will increase 5% okay in 

year three to year five. So year three through five, okay? After a few years, you  may apply a long term cash flow growth rate representing an assumption of the  annual growth from that point on this value. You should probably not exceed the  

long term growth prospects of the overall economy by too much. We will say that the company X is 3% so that's the long term growth rate is 3% growth rate  equals 3% you will then calculate weighted average cost of capital. Let's say, for example, our weighted average cost of capital is 8% the terminal value, or long  term valuation of the company's growth approaches is calculated using the  Gordon growth model, terminal value. So Gordon growth model, all right,  Gordon growth model, terminal value. So let's say terminal value equals  projected cash flow for the final year times one plus the long term growth rate  divided by the discount rate, or weighted average Cost of capital minus the long  term growth rate. Now you can estimate the cash flow for each period, including  the terminal value. So $50 is our cash flow at period zero. So we took $50 times  one plus the rate of return. It's our weight and average cost of capital, which is  10% so 50 times 1.0 gives us 55 and we project out cash flows like this. Now  notice our growth rate changes, right? So our return changes, so we go from  10% in years one and two to 5% in three, four and five, and then calculating the  terminal value, we will use our long term growth rate of 3% okay, so now we  know the cash flows. We know the terminal value. You can see how they've  been discounted back right? So now we know the present value of those cash  flows. So finally, to calculate company X's discounted cash flow, you add each of these projected cash flows, adjusting them for present value using the weighted  average cost of capital. So we're going to take these cash flows, 55 60.5 63.5, 3  66.7 70.04 and 1,442.75 and we're going to put them into our discounted cash  flow formula. So let's look at how this is going to compute. So we have for cash  flow one, so Company X equals So cash flow 1 55, divided by 1.081 why do we  use 1.081 so we'll take the $55 cash flow, we'll multiply that out by one plus our  weighted average cost of capital. Then we'll take our next cash flow, cash flow  two 60.5 divided by one plus our growth rate. But this will also be raised to the  second power next, our other next cash flow, 63.53 divided by 1.08 raised to the third. Next cash flow 66.70 divided by 1.08 raised to the fourth plus 70.04 point  04, divided by 1.08 raised to the fifth plus 1442.75 divided by 1.08 This is our  terminal value, raised two. The fifth this will give us $1,231.83 so this is the sum  of our cash flows into the future. So now we're going to multiply this out by a  million to give us our present enterprise value of company X, which will be 1.23  billion. So this is our estimated present enterprise value for company X, so if the  company has net debt, this needs to be subtracted as equity holders claims to a  company's assets are subordinate to bond holders. The result is an estimate of  the company's fair equity value. If we divide that by the number of shares  outstanding, say, divided by 10 million shares. All right, 10 million shares. 10  million shares, we have a fair equity value per share of $123.18 which we can 

compare with the market price of the stock if our estimate is higher than the  current stock price, we might consider Company X a good investment.