Discounted Cash Flow Analysis Fundamentals.

DCF Analysis is one of the most popular valuation methodologies in use today.

DCF Analysis offers several advantages over other valuation methodologies:

Advantage nr. 1: Ability to customize the financial model which is the basis for the valuation to any given business situation.

DCF Analysis is most universal and can be used to value any business, provided a reasonable financial forecast can be created.

Knowledge of financial modelling techniques allows to customise the financial model for any business venture and business development scenario. As such, using the DCF Analysis we can value any business no matter how unique the business model is. This is in sharp contrast to the Comparable Trading Analysis which can be used to value a given business only if comparable public companies do exist and if financial forecasts are available for these comparable companies.

Advantage nr. 2: Ability to select an appropriate discount rate wacc which specifically addresses a unique circumstances of a given capital market

Since the applicable discount rate wacc is individually calculated for each DCF valuation analysis, a high level of flexibility exists to capture the reality of a given capital market. Wacc calculation includes the following main factors:

a) risk free rate of interest of a given capital market (e.g. T-Bills in the USA)

b) risk premium commended by equity investors over risk free investments in a given capital market

c) Beta of a given business (Beta measures how sensitive the equity return of a given company is in relation to the market return (e.g. return of S&P 500 index) Beta = 0 means that the returns are not correlated at all (Beta can be negative) Beta = 1 means that the return of a company is 100% correlated with the return of the market.

Advantage nr. 3: Ability to run sensitivity analysis

Sensitivity analysis is the analysis which tests how sensitive the outcome of the valuation is to the changing values of the key inputs and assmptions. Since valuation is more of an art than science, sensitivity analysis is highly useful in negotiating and agreeing what the value of a given company is, as it allows to position the valuation as a range of values, rather than a single value.

Most popular inputs which are being tested in the sensitivity analysis for a company being valued include:

Growth rate of revenues, EBITDA, EBIT and Net Income margins, Level of corporate synergies (esp. In M&A transactions), Working capital assumptions, CAPEX levels, Obtaining new debt, paying faster existing debt, Obtaining funds through an IPO or an SPO, Wacc inputs (risk free rate, risk premium, Beta), The growth rate g of Free Cash Flow after the Terminal year.

Advantage nr. 4: Ability to perform valuation analysis which is almost totally independent from the prevailing capital market conditions

Since DCF Analysis considers business model of a company being valued in great detail and only based on specific business metrics, it is possible to capture the "true" value of a company being valued with reference only to its specific situation and without regard for the overall capital market conditions.

This is very important as sometimes the capital markets are influenced heavily by prevailing macroeconomic conditions, e.g. during recession years valuation of companies fall in general. This way some good companies are "punished" by the markets without good reason. This is one of the most important limitations of Comparable Transaction methodology.

Main disadvantages of the DCF Analysis include:

Disadventage nr. 1: High dependence on the chosen assumptions

Outcome of the DCF Analysis is highly dependent on several key assumptions. Some of the most important assumptions where judgement is exercised include the wacc components, the Free Cash Flow growth rate "g" after the Terminal Year, the revenue growth rate, the EBIT, EBITDA and Net Income margin assumptions and the Working Capital assumptions. This limitation can be addressed by running sensitivity analysis.

Disadventage nr. 2: The necessity to prepare a financial model

Unfortunately DCF Analysis requires preparation of a comprehensive financial model of a company being valued. It is an intensive and labour consuming process which requires a considerable technical expertise.

In summary it seems that advantages of the DCF methodology outweigh the disadvantages, and DCF Analysis will remain in the foreseeable future one of the most important and universal company valuation methodologies.

DCF Analysis is extensively used for:

Company valuations for the Merger and Acquisition transactions

Compliance valuations

Investment analysis for the venture capital and private equity investors

Restructuring valuation analyses

Specialized reports required by the IFRS (intangible asset valuations and purchase price allocations; goodwill impairment analysis)

Reports supporting litigation and dispute resolution (e.g. income loss reports)

Analysis prepared for the legal opinions and expert testimony used in the court trails



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