This is a simple example to show the workings of a Discounted Cash Flow (DCF) model, which is hopefully also understandable for non-mathematicians.
Using cash-flow-based measurement techniques is done using all the following factors:
- estimates of future cash flows. DCF Calculation – Value of the business
- possible variations in the estimated amount or timing of future cash flows for the asset or liability being measured, caused by the uncertainty inherent in the cash flows.
- the time value of money. DCF Calculation – Value of the business
- the price for bearing the uncertainty inherent in the cash flows (a risk premium or risk discount). The price for bearing that uncertainty depends on the extent of that uncertainty. It also reflects the fact that investors would generally pay less for an asset (and generally require more for taking on a liability) that has uncertain cash flows than for an asset (or liability) whose cash flows are certain. DCF Calculation – Value of the business
- other factors, for example, liquidity, if market participants would take those factors into account in the circumstances.
THE CALCULATION MODEL DCF Calculation – Value of the business
Five years a free cash flow of 100 and a terminal value for the rest of the life of the business of 300. The discount rate is 10% (see DCF, (1+i) is 1 plus 10% = 1.10). The Discounted Cash Flow value here is:
91 + 83 + 75 + 68 + 62 + 186 = 565. DCF Calculation – Value of the business
The nice thing of this model is you can easily see the ‘Time value of money’.
100 cash inflow at the end of 2018 is worth 91 at the beginning of 2018 (cash inflow assumed available at the end of 2018 (yes it is a simple model !)). But the cash inflow at the end of 2022 is worth only 62 at the beginning of 2018.
This also shows one of the big upsides of a DCF model, the further away in the future the lower the contribution of the cash inflow to the value of the business, or in other words the years the closest to historical financial data (which because it is history is believed to be the most accurate, which in case of cash is kinda true) weigh in the most. In addition the terminal value, representing all future cash flows after 2022 (the last detailed cash flow year) only weighs in for 33%.
Now a slightly more complicated model.
- 1 January YR1 is the valuation date,
- The pre-tax discount rate is 24% (this incorporates (c) the time value of money, (d) and (e) above at a pre-tax level). One of the other factors ((e) above) is a 3% annual growth after year 5 see last piont in this list)),
- The pre-tax capitalization rate to capitalize the perpetual annual cash flows from year 5 (150,300) to the business model terminal value is also 24%,
- The pre-tax fully adjusted cash flow is modeled to be received at the end of each year (model simplification),
- No long-term sustainable growth is assumed (the cash flow in year 5 will be generated for an indefinite period of time), If sustainable growth had been included, the pre-tax discount rate would have had to be reduced by 3%, so a 3% growth is included.
Here are the Discounted Cash Flow calculations:
Just look into the table, each calculation is detailed by (a) – (i) and the actual math shows in calculations. Compare this table to the calculation picture above to better understand the calculations.
These are still very simple models, the whole income and expense structure can be modeled to end in a pre-tax adjusted cash flow, which in general could come close to EBITDA less cash outflows representing a certain level of replacement investments.