What are DCF models and it’s types | formula calculation with example

The Discounted Cash Flow (DCF) model is a key financial tool to find the fundamental value of an investment, such as a company or project, based on its future possibilities. The idea is based on a simple concept: money you have today is worth more than the same amount in the future because you can invest money today to earn interest on it. Therefore, a DCF works by estimating all the future cash flows it expects the investment to generate, and then applying a “discount rate” (which considers risk and the time value of money) to mathematically reduce those future cash amounts to its present value in today’s dollar value; this is important because you are interested in knowing the value of the investment today. The future cash flow amounts are discounted using a discount rate, and the sum of all the discounted cash flows gives you the intrinsic value of the investment; then, based on what you believe are the investment’s value compared to its price, you can determine whether you feel the investment is undervalued or overvalued.

What is a DCF model?

A Discounted Cash Flow (DCF) model is a financial valuation approach that estimates the valuation of an investment, company, or asset, based on the expected future cash flows that is then discounted to the present value. The DCF model is based on the rationale that money is worth more in the present than it is in the future because of its earning potential for the investor. The DCF model is commonly employed in finance for valuations of businesses, projects or investments.

The DCF model ascertains the present value (PV) of expected future cash flow by discounting the expected future cash flow to arrive at the present value, employing the discount rate which is typically the weighted average cost of capital (or WACC) or required rate of return, to discount the expected future cash flows to the present value to account for the time value of money and risk.

Types of DCF Models

Free Cash Flow to the Firm (FCFF) Model (also called Firm DCF or Unlevered DCF):

Suppose you want to purchase an entire lemonade stand, including the stand, pitcher, and cups, but you need to assume its small loan from a friend who lent you the money for lemons. To determine a fair purchase price, you need to estimate the stand’s real profits for whomever owns it, which is unpaid cash left over after you paid for sugar, lemons, and new cups (this is operating cash flow); minus your obligations to reinvest into the business, primarily, the addition of a new pitcher. That number is Free Cash Flow to the Firm (FCFF), the cash that is available to whomever finances the business, you (the owner) and your friend (the creditor). In the context of a FCFF model, you can forecast those annual cash flows for several years and then discount them back using a measure called WACC, which represents the appropriate return that the owner and creditor require together on their respective investments.

Free Cash Flow to Equity (FCFE) Model (also called Equity DCF or Levered DCF):

You can think of the Free Cash Flow to Equity (FCFE) model as looking solely at what is left for you, the owner, after everyone else has been paid. Let’s say you own a small apartment building; the rent you collect is not your money because you first must pay back the mortgage lender, pay for maintenance, and even borrow additional money for improvements. FCFE talks about the actual cash that you, as the owner, have available after accounting for all operating expenses, required investment in the property, and debt transactions (both paying back old debt and taking on new debt). This is why we refer to it as a “levered” or “equity” DCF, because it accounts for the company’s debt. In order to value your interest, you then project these cash flows (the FCFE) specific to owners and apply a discount rate called the “Cost of Equity,” your expected return for accepting the investment’s risk. The final number is the value of just the equity interest, or what your interest in the business is worth, independent of the debt businesses have.

DCF Formula

DCF = CFt/(1+r)^t + TV/(1+r)^n

Where:

• TV: Terminal value, which estimates the value of cash flows beyond the forecast period.
• CFt: Cash flow in year t t t.
• r: Discount rate (WACC for FCFF or cost of equity for FCFE).
• t: Time period (year).
• n: Number of forecast periods.

Terminal Value (TV) Calculation

The terminal value accounts for cash flows beyond the explicit forecast period and is calculated using one of two methods:

Gordon Growth Model (Perpetuity Growth Method):

TV = CF(n+1)/(r-g)

Where:

• CF(n+1): Cash flow in the first year after the forecast period.
• g: Perpetual growth rate (typically tied to GDP growth or inflation, e.g., 2–3%).

Exit Multiple Method:

TV= CFn*Exit Multiple

Where the exit multiple is based on a metric like EBITDA or revenue, derived from comparable companies.

Steps in DCF Valuation

Forecast Free Cash Flows:

• For FCFF: Calculate free cash flow to the firm.
  • FCFF = EBIT*(1-Tax Rate) + Depreciation and Amortization – Capital Expenditures – Change in working capital
• For FCFE: Calculate free cash flow to equity.
  • FCFE = Net Income + Depreciation and Amortization – Capital Expenditures – Change in working capital + Net borrowing

Determine the Discount Rate:

• For FCFF: Use WACC.
  • WACC = (E/V)*r_e + (D/V)*r_d*(1-T)

Where:

• E: Market value of equity.
• D: Market value of debt.
• V: Total value (E+D).
• r_e​: Cost of equity (e.g., from CAPM: re=rf+β×(rm−rf)).
• r_d​: Cost of debt.
• T: Tax rate.

• For FCFE: Use the cost of equity.

Calculate Terminal Value:

• Use the perpetuity growth model or exit multiple method.

Discount Cash Flows:

• Discount each year’s cash flows and the terminal value to the present using the appropriate discount rate.

Sum the Present Values:

• Add the present values of the forecasted cash flows and terminal value to get the total value.
• For FCFF: This gives the enterprise value (EV). To find equity value, subtract net debt (Debt – Cash).
• For FCFE: This directly gives the equity value.

Example: Two-Stage FCFF DCF Valuation

Scenario: Valuing a company with the following assumptions:

• FCFF for Years 1–5: $100M, $110M, $120M, $130M, $140M.
• WACC: 10%.
• Perpetual growth rate: 2%.
• Net Debt: $200M.

Step 1: Forecast Cash Flows (Given)

• Year 1: $100M
• Year 2: $110M
• Year 3: $120M
• Year 4: $130M
• Year 5: $140M

Step 2: Calculate Terminal Value

• FCFF in Year 6 = FCFF_5*(1+g) = 140*(1+0.02) = 142.8M.
• Terminal Value = 142.8/(0.10-0.02) = 142.8/0.08 = 1,785M.

Step 3: Discount Cash Flows and Terminal Value

• Present Value (PV) of FCFF:
  • Year 1: 100/(1+0.10)^1 = 90.91M
  • Year 2: 110/(1+0.10)^2 = 90.91M
  • Year 3: 120/(1+0.10)^3 = 90.16M
  • Year 4: 130/(1+0.10)^4 = 88.74M
  • Year 5: 140/(1+0.10)^5 = 86.94M
• PV of Terminal Value: 1,785/(1+0.10)^5 = 1,108.02M

Step 4: Sum Present Values

• Enterprise Value = 90.91+90.91+90.16+88.74+86.94+1,108.02 = 1,555.68M.

Step 5: Calculate Equity Value

• Equity Value = Enterprise Value – Net Debt = 1,555.68 – 200 = 1,355.68M

Conclusion

In essence, Discounted Cash Flow (DCF) models provide a value of a company or investment by estimating the future cash flows and discounting them back to today’s value. The fundamental premise of using DCF is that money that you have today is worth more than money you will have in the future due to the opportunity to earn returns. While there are many varieties of DCF models available, there are generally three main types – FCFF (free cash flows to the firm) which models the value of the entire business, FCFE (free cash flows to equity) which enables analysis specifically valued at equity, and Dividend Discount Model (DDM) which is used for companies that pay dividends. Depending on the model, DCF uses a base formula to discount projected cash flows to a present value, using some discount rate known as either WACC (weighted average cost of capital) or the cost of equity, including a long-term terminal value in projections. For example, in the FCFF model example, just as projected cash flows were discounted back in a DCF, we determined the value of equity was $1,355.68 million after subtracting debt. DCF may be one of the most powerful analysis tools available to analysts, but it is also heavily reliant upon the accuracy of the assumed cash flows and growth rates in the future, which is why care should be exercised when conducting analysis using this specific methodology.

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