The profit that is materialize as an investor/business owner is not restrict to dividends/profit only. The final sale value of asset is a major part of your overall return.
There are numerous methods of valuation currently use in the market:
- relative valuation,
- net assets value,
- discounted cash flows, and
- market comps.
Discounted cash flow is a widely use method for valuation, often used for evaluating companies with strong projected future cash flow.
This is the only method which assigns more importance to future cash generation capacity of the company – not the current cash flow.
Our Discounted Cash Flow Valuation Template is design to assist you through the journey of valuation. The template comes with various scenarios along with sensitivity analysis.
What is Discounted Cash Flow Valuation?
Discounted cash flows allows you to value your holdings based on cash flows to be generated over the future period. These cash flows are then discounted using discount rate, termed ‘cost of capital,’ to arrive at the present value of investment.
Also, The reason behind discounting the cash flows is that the value of $1 to be earned in future may not be the same as the value today.
The value calculated through this method is then compared to the cost of investment today to evaluate whether same is profitable or not. Higher value in comparison to its cost of acquisition denotes a profitable opportunity can be materialized by the investor.
Discounted Cash Flow Analysis
The elements that are part of net present value (NPV formula) are:
- Cash flows over the future period: This represents the income earned in cash on any given security or investment. It is in form of interest, dividend, or profit.
- Discount rate or cost of capital: This is require rate of return that an average investor expects to receive from the investment. Moreover, The same is also refer to as the weight average cost of capital. To learn more about the discount rate.
- Number of years under projection: Hence, Cash flows earned are discount at the cost of capital for the period to which it relates. Usually the period may be monthly, quarterly or yearly depending upon the frequency of cash flows.
- Terminal Value: Cash flows from an investment may run for an infinite period (theoretically). Also, An investor can not always correctly determine the period for which he will keep on receiving the cash flows. The concept of terminal value is use to solve this.
Thus, A single value is estimate at the end of 5 or 10 years which is the representative of the total value over the future period. So, The same is also discount at the cost of capital to arrive at the net present value (NPV).
There are multiple formulas to calculate the terminal value. The top methods are:
- Exit multiple (EBITDA or sales or PE multiple),
- Perpetual growth rate, and
- No growth formula.
How to Use The Template
Moreover, You can execute your own DCF valuation model by inserting some basic data into the template. In this article, we break down the entire procedure into simple steps.
Thus, To use the template, you will need to replace data that is in blue with your own information.
Although the method is widely use by investors, sometimes it may produce misleading figures. Thus, It may happen in the case where the company sells its assets to inflate the cash flows, while the actual earnings of the company may be zero or negligible.
On the other hand, if you use it wisely, especially by considering each minor detail that is use in the calculation of cash flows, the method is consider as the most reliable valuation model.