Framework library · Finance and valuation

DCF valuation

A DCF values a business as the cash it will generate for all its investors, discounted at the return those investors require. The forecast years are discounted one by one, and everything after them is captured in a terminal value. In infrastructure businesses the terminal value is often most of the answer, so the discount rate and the long-run growth rate deserve more scrutiny than the forecast.

LevelAdvanced
TimeA day for a first model once the forecast exists; longer to defend the discount rate
Who to involveFinance or corporate development, with the managers who own the forecast and someone whose job is to challenge the terminal value.
Also calleddiscounted cash flow valuation, DCF model, enterprise value, free cash flow valuation, Gordon growth model, intrinsic value

Use it when

  • You are buying, selling or raising money against a business or a portfolio of assets, such as a fibre network or a set of towers.
  • The cash flows can be forecast with some confidence, as with contracted or infrastructure revenue.
  • You want to test what a market price implies about growth and returns.
  • Two parties disagree on value and you need to show which assumptions drive the gap.

Avoid it when

  • You are deciding whether to fund one project inside the business. Use investment appraisal, which compares the project's NPV and IRR with a hurdle rate.
  • Cash flows stay negative for many years and the value rests on options, as in an early-stage venture. Use scenario planning or a decision tree.
  • Good comparable transactions exist and the question is what the market pays. Use comparables alongside the DCF, as in spectrum valuation by comparables, rather than the DCF alone.

How to run it

  1. Forecast free cash flow

    EBITDA less capital expenditure less cash tax and working capital, year by year, until the business reaches a steady state.

  2. Set the discount rate

    The weighted average cost of capital (WACC): the returns debt and equity holders require, weighted by how the business is financed. Write down where each part came from.

  3. Set a normalised final year and long-run growth

    The terminal value uses free cash flow in a typical steady year, with capital expenditure at maintenance level, growing at a rate no higher than the long-run economy.

  4. Discount and add up

    The present value of the forecast plus the present value of the terminal value is enterprise value. Less net debt it is equity value; divided by shares it is value per share.

  5. Read the sensitivity table

    Enterprise value across a grid of discount and growth rates shows how much of the answer is assumption. Report a range, not a point.

Work through it

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Mistakes to avoid

  • Basing the terminal value on a build-phase year. Heavy capital expenditure in the final forecast year understates value, and a final year with no replacement spending overstates it.
  • Setting a terminal growth rate close to the discount rate. The terminal value then balloons. The workbench returns nothing when growth reaches WACC, but anything within three points of it deserves a hard look.
  • Mixing nominal cash flows with a real discount rate, or the reverse. The first overstates the value and the second understates it, by the inflation compounded over every year of the forecast.
  • Presenting one number when most of the value sits in the terminal value. Show the table.

Where it comes from

The principle that an asset is worth the present value of the cash it will produce is set out in Irving Fisher, The Theory of Interest (1930), and was applied to the valuation of companies by John Burr Williams in The Theory of Investment Value (Harvard University Press, 1938). The constant-growth terminal value used here is the Gordon growth model, from Myron J. Gordon and Eli Shapiro, "Capital Equipment Analysis: The Required Rate of Profit", Management Science 3(1), 1956. Source.

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