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DCF1

The document discusses discounted cash flow (DCF) analysis for valuing companies. It explains that DCF takes into account future cash flows but requires accurate forecasts that are sensitive to small changes. Most of a company's value lies beyond the typical 5-10 year forecast period, so calculating the terminal value is important but difficult. The document recommends using a terminal growth rate consistent with investment levels or treating the company as a cash cow. It also describes using DCF to determine absolute value, for scenario analysis, or to imply a discount rate based on current price. Overall, DCF provides a rigorous valuation approach compared to traditional techniques.

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163 views1 page

DCF1

The document discusses discounted cash flow (DCF) analysis for valuing companies. It explains that DCF takes into account future cash flows but requires accurate forecasts that are sensitive to small changes. Most of a company's value lies beyond the typical 5-10 year forecast period, so calculating the terminal value is important but difficult. The document recommends using a terminal growth rate consistent with investment levels or treating the company as a cash cow. It also describes using DCF to determine absolute value, for scenario analysis, or to imply a discount rate based on current price. Overall, DCF provides a rigorous valuation approach compared to traditional techniques.

Uploaded by

suttamarle
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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UBS Global Research Valuation Series

Discounted Cash Flow (DCF)


Analysis

Associated titles in the Double-edged sword


UBS Valuation Series: Unlike traditional techniques, discounted cash flow (DCF) valuations
Evaluation methodology take into account the explicit financial performance of all future
Cost of equity and of capital
years. However, such valuations are very sensitive to small changes
in input data and while providing the scrupulous analyst with a very
Dividend discount models
powerful tool, the unscrupulous can use the technique to justify
Economic value added
just about any value they choose!
HOLT

The advantage of a DCF valuation is that it allows the free cash flows that occur
in all future years to be valued giving the 'true' or 'intrinsic' value of the business.
The disadvantage is that it requires accurate forecasts of future free cash flows
and discount rates. Typically, explicit free cash flow forecasts are produced for 5 to
10 years. However, in general, the bulk (often 80% or more) of the value lies
beyond this explicit forecast period, and this is captured in a terminal value
calculation. The accuracy of this calculation is not only a function of the method
used and the underlying assumptions, but also the level of cash flow at the end of
the explicit forecast period.
Traditional valuation multiples are often used to calculate terminal value.
However, it is difficult to estimate the fair value multiple for the company some 5
to 10 years hence, and this introduces an unacceptable level of inaccuracy.
A better approach to terminal value is to represent the free cash flows
beyond the explicit forecast period in terms of a terminal growth rate and continue
the DCF analysis in perpetuity. This growth must be consistent with the level of
investment and return on investment, an issue which is often overlooked. An
alternative is to treat the company as a cash cow and assume a decay rate in the
gross cash flows, this eliminates the need to assess the ongoing level of investment.
With these points in mind, a DCF analysis can be used in three
ways: (1) As a measure of absolute value. A DCF analysis will provide an absolute
value and it is always useful to 'sense check' this against an implied traditional
multiple (eg EV/EBITDA, PE, P/BV, etc). (2) As a tool in scenario analysis. These
scenarios should reflect company specific factors rather than macro factors, which
affect the value of all other companies in the market as well as the company being
valued. Each scenario should use the same discount rate. (3) In a calculation of an
implied discount rate based on current price and forecast free cash flows. This
discount rate can be compared with those of other companies and/or a theoretical
discount rate. This approach has the advantage that it permits relative valuations.
John Wilson
Tel (+44) 171 901 3319 Overall, DCF valuations provide a more rigorous valuation approach than
john.wilson@ubs.com
traditional techniques.

August 1997 UBS Limited


A Member of the Union Bank of Switzerland Group
100 Liverpool Street
London
EC2M 2RH

101150 Tel (+44) 171 901 3333, Fax (+44) 171 901 2345

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