Discounted Cash Flow (DCF, NPV, IRR, FCF) Resources
Last Updated by WikiWealth
Table of Contents
What is the Discounted Cash Flow (DCF) Analysis, NPV, FCFF, FCFE, and IRR?
The discounted cash flow (DCF) analysis is the balance of the amounts of cash being received and paid by a business during a defined period of time. Sometimes these payments are tied to specific projects. Other times, these payments, or cash flows, originate from a specific company. The result of these calculations determines the value of a company or project.
- When valuing a Business, the discounted cash flow (DCF), meaning the cash flow generated by the business discounted by a rate that equals the risk to those future cash flows. The accumulation of the future cash flows discounted by risk subtracting debt, is the value of the business.
- What is the Net Present Value (NPV)? The NPV is essentially a discounted cash flow analysis. Inputs and outputs of cash are discount to the present value. This procedure can be done for projects or businesses.
- What is the Internal Rate of Return (IRR)? The IRR is the rate of return that makes the inputs and outputs of cash equal in the present value. The IRR is important to calculate as a yardstick for determining whether to start a project. For example, if the project in question had a potential IRR of 10%, but the bank could only loan money at 15%, then it is not advisable to start that project; the inverse is also true.
- What is Free Cash Flow (FCF)? Free cash flow is the cash available to investors. It is generated by the operations of the business. An increase in free cash flow leads to an increase in the value of the business. In corporate finance, free cash flow (FCF) is a cash flow available for distribution among all the security holders of a company. They include equity holders, debt holders, preferred stock holders, convertibles holders, and so on.
- What is the Free Cash Flow to Equity (FCFE)? This is the cash flow that goes only to equity holders of capital. When computing cash flow, an analyst would take out all payments to debt holders, with the residual cash flow going only to equity holders. In such a scenario, the discount rate has to match the risk to equity holders only; therefore, an analyst uses the CAPM (capital asset pricing model).
- What is Free Cash Flow to the Firm (FCFF)? This is the cash flow that goes to all the capital holders in a company: preferred, debt, and equity. An analyst must match up the risk of cash flow with a discount rate that equates to that risk. WikiWealth uses the WACC (weighted average cost of capital) in this example.
- What is the difference between the NPV and DCF? There is no difference between the the NPV and DCF; however, analyst use them for difference reasons. Usually, the DCF is meant to calculate complicated investments such as companies, which may have many cash flow assumptions, equations, inputs and outputs. The NPV is typically easier to use for simple projects, where an analyst has a definite time period and measurable cash inflows and cash outflows. In both cases, an internal rate of return (IRR) can determine the total expected rate of return and the discount rate (or present value factor) must match the riskiness of the project.
Importance of the DCF and NPV to Investors
An increase in the free cash flow (FCF) of a business means that owners (investors) are entitled to that money. Either the business reinvests the cash to produce more cash in the future, or the business gives away the cash to investors as a dividend. In either case, a business is worth more when cash flows increase. When a company does a share buyback, they are decreasing the number of shares (thus shareholders) to increase the proportion of cash available to the remaining shareholders.
How Does Wikiwealth Create Company Projections for the DCF and NPV?
Wikiwealth makes conservative projections bases on the company’s historical results. We provide beginning projections, but they are only a base for members of Wikiwealth to modify. All projections are transparent and are subject to critiques by any visitor of the site. Conservative projections entail the following:
- Revenue: A revenue growth rate, which trails down to the long term inflation rate. We trail down projections, because over the long term, companies experience slower growth as their markets mature. It is much harder for Microsoft to grow at 50% a year versus the growth rate of a small technology company. In rare cases, a company can grow very quickly over a period of time past our 10 year projection horizon, but those predictions would be unreliable and aggressive, so we would rather stay conservative. There are plenty of investment opportunities in the market where you don’t have to make a guess about above average growth 10 years from now. Wall Street has a hard enough time projecting earnings every three months.
- Costs: Cost (COGS and operating expenses) are expected to remain the same as in previous years. In most cases, the historical cost margins will stay the same in the future. For example, if COGS were 50% of revenue, we estimated that the percentage would remain the same. An aggressive assumption entails those cost decreasing over time. Again, we rely on the critiques of our members to determine the most appropriate cost estimates. If an investor expects cost to decrease, they need to know at what rate those cost should decrease and at which point the cost, as a percentage of revenue, will stop decreasing. This can be determined by looking at industry or competitor cost statistics.
- Taxes: Taxes, in most cases, are an average of the historical period. Taxes are subject to wild swings, so there might be small outlier years where the tax rate was not consistent. In those cases, we tend to take an average excluding the outlier year. Why do company-specific taxes and the after-tax rate on debt interest differ? They differ because we find the tax rate on EBIT for the company specific projections, which includes interest expenses. Sometimes the historical tax rate is zero or negative. In those cases, Wikiwealth may project zero taxes for a short period, but after which the tax rate goes up to the domestic corporate tax rate, which in the US is 40%.
- Depreciation, Amortization & Capital Expenditures: Depreciation and amortization (D&A), and capital expenditures (CapEx): These costs are all projected using historical information. CapEx uses the cost percentage of revenue in the most recent year. D&A regresses to the capital expenditure percentage of revenue over time regardless of if it is higher or lower than the current D&A percentage of revenue. We make the assumption that D&A and CapEx equal in the terminal year (last year of projections), because over time – and in a steady market – the money spent on new equipment (CapEx) should equal the cost (depreciation) of that equipment over time. In some cases tax and growth policies dictate that a gap between D&A and CapEx remain into perpetuity. These assumption will improve over time as our models become more sophisticated. Any suggestions would be greatly appreciated.
- Working Capital: Working Capital: We calculate working capital as current assets minus excess cash, minus current liabilities, and plus short term debt. We use this equation to equate the most accurate measure of the working capital requirement of the target company. We initially assume that excess cash is not invested in any activities of the company, whereas, short-term debt was acquired to fund a specific investment activity. Wikiwealth projects that working capital will remain the same (as a percentage of revenue) as in the latest historical period. Changes in Working Capital: Since working capital is a balance sheet item, only changes in working capital matter to the investment valuation. An increase in working capital requires the use of cash flows, whereas, a decrease means more cash flow is available to the investor. In other words, a decrease in working capital means that the company is becoming more efficient in their use of assets.
- Free Cash Flow: Free cash flow equals NOPAT plus depreciation minus capital expenditures minus the change in working capital. We add depreciation to free cash flow, because depreciation is a non cash expense that provides a tax shield. We took out depreciation before we calculated the tax expense, so now we add it back. Free cash flow is used to purchase capital expenditures, therefore, we subtract capital expenditures in the free cash flow equation.
Determine Share Value Using The Discounted Cash Flow (DCF) Analysis?
- The present value factor is the discount rate calculated in such a way to make it more informative for audit purposes.
- Invested Capital is the value of both equity and debt since the valuation measures the value to all capital participants of the company.
- Cash: We add cash back to the valuation, because cash is part of the value of the company, but it is not included in the free cash flow valuation unless it is part of the operations of the business. For example, if a company has no operations, therefore no value according to the cash flow valuation model, then the company is only worth the cash used to fund the balance sheet. Unless the cash is used to fund the operations of the business, it is usually just cash on the balance sheet, but it still adds to the value of the company.
- Interest-bearing debt: is found on the target company’s balance sheet. We find the value to the entire firm (debt and equity holders), so subtracting debt from this section of the company’s value, leaves the value of equity.
- Lastly, we divide the value of equity by the shares outstanding to give the value of equity per share (or, share price).
How Do I Calculate the IRR Using WikiWealth's Discounted Cash Flow Models?
The IRR is an easy concept to understand. The IRR is the discount rate that makes net outflows of cash equal to the net inflows of cash. The higher the discount rate and the further out the cash flows, the smaller the total amount of cash this project or business will generate.
- How can you understand the IRR using WikiWealth's analysis? WikiWealth produces specific calculations for thousands of companies. When companies are undervalued, meaning they have positive investment potential, the IRR for those companies is higher than their discount rates; the inverse is also true. For example, if the discount rate is 10%, but the company is undervalued, then the IRR is higher than 10%.
- How Do I Find the Exact IRR? Click on WikiWealth's "Experimental Mode" link to experiment with WikiWealth's actual analysis. See our tutorial if you need further help. Next, find the discount rate / present value factor on the discounted cash flow model. Change the discount rate until the concluded stock price on the DCF matches the current stock price of the company. This is your IRR.
The accuracy of the data included in WikiWealth is a product of the efforts of our members. Members check data and projections and make changes if there are errors. We make sure to pick the most experienced members to ensure quality and accurate data. WikiWealth does not directly employ stock researchers; otherwise, the service would not be free. Instead, WikiWealth relies on our members to check, improve and maintain the quality of our research.