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Valuation using discounted cash flows (DCF valuation) is a method of estimating the current value of a company based on projected future cash flows adjusted for the time value of money. The cash flows are made up of those within the “explicit” forecast period, together with a continuing or terminal value that represents the cash flow stream after the forecast period. In several contexts, DCF valuation is referred to as the "income approach". Discounted cash flow valuation was used in industry as early as the 1700s or 1800s; it was explicated by John Burr Williams in his The Theory of Investment Value in 1938; it was widely discussed in financial economics in the 1960s; and became widely used in U.S. courts in the 1980s and 1990s. This article details the mechanics of the valuation, via a worked example; it also discusses modifications typical for startups, private equity and venture capital, corporate finance "projects", and mergers and acquisitions, and for sector-specific valuations in financial services and mining. See Discounted cash flow for further discussion, and Valuation (finance) § Valuation overview for context. Basic formula for firm valuation using DCF model Value of firm = ∑ t = 1 n F C F F t ( 1 + W A C C t ) t + [ F C F F n + 1 ( W A C C n + 1 − g n + 1 ) ] ( 1 + W A C C n ) n {\displaystyle \sum _{t=1}^{n}{\frac {FCFF_{t}}{(1+WACC_{t})^{t}}}+{\frac {\left[{\frac {FCFF_{n+1}}{(WACC_{n+1}-g_{n+1})}}\right]}{(1+WACC_{n})^{n}}}} where FCFF is the free cash flow to the firm (essentially operating cash flow minus capital expenditures) as reduced for tax WACC is the weighted average cost of capital, combining the cost of equity and the after-tax cost of debt t is the time period n is the number of time periods to "maturity" or exit g is the sustainable growth rate at that point In general, "Value of firm" represents the firm's enterprise value (i.e. its market value as distinct from market price); for corporate finance valuations, this represents the project's net present value or NPV. The second term represents the continuing value of future cash flows beyond the forecasting term; here applying a "perpetuity growth model". Note that for valuing equity, as opposed to "the firm", free cash flow to equity (FCFE) or dividends are modeled, and these are discounted at the cost of equity instead of WACC which incorporates the cost of debt. Free cash flows to the firm are those distributed among – or at least due to – all securities holders of a corporate entity (see Corporate finance § Capital structure); to equity, are those distributed to shareholders only. Where the latter are dividends then the dividend discount model can be applied, modifying the formula above. Use The diagram aside shows an overview of the process of company valuation. All steps are explained in detail below. Determine forecast period The initial step is to decide the forecast period, i.e. the time period for which the individual yearly cash flows input to the DCF formula will be explicitly modeled. Cash flows after the forecast period are represented by a single number; see § Determine the continuing value below. The forecast period must be chosen to be appropriate to the company's strategy, its market, or industry; theoretically corresponding to the time for the company's (excess) return to "converge" to that of its industry, with constant, long term growth applying to the continuing value thereafter; although, regardless, 5–10 years is common in practice (see Sustainable growth rate § From a financial perspective for discussion of the economic argument here). For private equity and venture capital investments, the period will depend on the investment timescale and exit strategy. Determine cash flow for each forecast period As above, an explicit cash flow forecast is required for each year during the forecast period. These must be "Free cash flow" or dividends. Typically, this forecast will be constructed using historical internal accounting and sales data, in addition to external industry data and economic indicators (for these latter, outside of large institutions, typically relying on published surveys and industry reports). The key aspect of the forecast is, arguably, predicting revenue, a function of the analyst's forecasts re market size, demand, inventory availability, and the firm's market share and market power. Future costs, fixed and variable, and investment in PPE (see, here, owner earnings) with corresponding capital requirements, can then be estimated as a function of sales via "common-sized analysis". At the same time, the resultant line items must talk to the business' operations: in general, growth in revenue will require corresponding increases in working capital, fixed assets and associated financing; and in the long term, profitability (and other financial ratios) should tend to the industry average, as mentioned above; see Financial modeling § Accounting, and Sustainable growth rate § From a financial perspective. Approaches to identifying which assum.... Discover the Frank J Fabozzi Cfa Sergio M Focardi Car popular books. Find the top 100 most popular Frank J Fabozzi Cfa Sergio M Focardi Car books.