In the financial world, using a disciplined valuation approach is a reliable anchor. The DCF model serves as a powerful tool for estimating the true value of assets.
Strategy 1: Foundations: Unlevered Free Cash Flows
Free cash flows (FCF) are a key indicator of a business's financial health, representing the money left after paying operating expenses and capital expenditures. For DCF valuation, it is recommended to use unlevered free cash flows (FCFF). This metric represents the cash available to all capital providers of the business. A precise calculation of FCF requires an understanding of the company's historical financial reports and projecting its future performance.
Strategy 2: Define Your Time Horizon
The DCF model is typically built in two stages: an explicit forecast period and terminal value. The explicit forecast period is a crucial component where an analyst projects detailed financial statements. The length of this period is not fixed and should be tailored to the business's lifecycle. For mature companies, this period is often set at five years, but it may be longer for companies with unpredictable cash flows.
Strategy 3: Mastering the Discount Rate
The discount rate plays a fundamental role in DCF analysis, serving as the rate used to reduce future cash flows to their present value. For unlevered DCF calculation, the Weighted Average Cost of Capital (WACC) is employed. WACC considers the required return from all capital providers of the company, weighted by their proportion in the company's capital structure. Even small changes in the discount rate can lead to significant shifts in the final valuation.
Building a robust DCF model requires a disciplined approach and deep understanding of its core components. This asset valuation method leads to more informed investment decisions.
