What is discounted cash flow?
Discounted cash flow is a method that seeks to value a company based on its ability to generate free cash flow in the future. Free cash flow is simply the cash a company has left after covering its operating expenses and making the necessary investments in its fixed assets. In other words, it's the money the business has available to pay dividends, reduce its debt, or reinvest in itself.
How to calculate DCF
At this point, you're probably wondering how discounted cash flow is calculated and what it takes into account, since it's based on a company's future capacity rather than on closed historical or current data. That's why you should know it's a complex method that takes several inputs into account.
The first is, precisely, the company's free cash flow, both current and in previous fiscal years. Based on that, a forecast is made for the desired number of years.
Next, you need to consider the discount rate, which reflects the company's risk and is used to discount future cash flows to the present. The discount rate is usually based on the weighted average cost of capital (WACC), which combines the company's cost of equity and cost of debt.
Once both figures are available for each year, the future cash flows are discounted using the discount rate with the following formula:
Free cash flow for year 1 / (1 + discount rate)1
Let's look at an example in which the discount rate is 10% and year 1 cash flow is 100,000:
100,000 / (1+0.10)1 = 90,909
This calculation would need to be done for each projected year to obtain a figure per year. These figures would then be added together to arrive at the DCF.
So we can say that the value of an asset depends on the cash flow it's expected to generate in the future, which makes this method essential in an M&A process: it helps us value the business correctly and avoid overpaying or earning a lower return than expected. If we can't calculate it ourselves, we can always contact an advisor or expert to help us value the company.
Difference between DCF and EBITDA multiples
Easier to calculate, the EBITDA multiple is used not only to value an SME but also to compare it with its competitors. So we can say that the two valuation methods are complementary indicators that, together, offer a more complete and objective view of the business's valuation.
DCF focuses on a stand-alone calculation for the company, while the EBITDA multiple takes the EV — the company's valuation, obtained by adding the estimated value of the business to its net debt (total debt minus cash and cash equivalents) — and divides it by EBITDA. Unlike discounted cash flow, this figure tells us nothing on its own, but it does when compared with similar companies.
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