How do you know how much an investment is worth? Conducting a discounted cash flow (DCF) analysis is the best way to arrive at an educated guess, whether you’re looking at the cost for a specific project, purchasing shares of a publicly traded company or investing in a private business.
Previously, we looked at how private and public comps help analysts compare companies in a similar growth stage and industry to determine a company’s current market value. When used along with an intrinsic valuation method like DCF analysis—which looks at the value of an investment based on its projected future cash flows—these models can help investors, business owners and transaction advisors gauge a company’s current market value and then assess if that company is under- or overvalued.
Here’s a quick overview of how DCF analysis works, and why it’s important to use in conjunction with public and private comps whenever assessing the value of a business.
What is discounted cash flow analysis?
DCF analysis is an intrinsic valuation method used to estimate the value of an investment based on its forecasted cash flows. It establishes a rate of return or discount rate by looking at dividends, earnings, operating cash flow or free cash flow that is then used to establish the value of the business outside of other market considerations.
In other words: It looks to answer the question, “How much money will I get from this investment over a period of time and how does that compare to the amount I could make from other investments?”
It does this by adjusting for the time value of money—which assumes a dollar invested today is worth more than a dollar invested tomorrow because it’s generating interest over that period of time.
How do you conduct discounted cash flow analysis?
To conduct a DCF analysis, assumptions must be made about a variety of factors, including a company’s forecasted sales growth and profit margins (its cash flow) as well as the rate of interest on the initial investment in the business, the cost of capital and potential risks to the company’s underlying value (aka discounted rate). The more insight into a company’s financials you have, the simpler it is to do.
With so many variables though, it’s easy to see why pricing a deal can be difficult and why most investors and transaction advisors choose to use multiple types of valuation models to inform their decision-making along with DCF analysis. An accurate answer helps inform how much an investment is currently worth—and which deals are worth walking away from.
Discounted cash flow analysis model
Here’s the basic formula for a simplified DCF analysis:
- DCF—Discounted cash flow, which is the sum of all future discounted cash flows that an investment is expected to produce
- CF—Cash flow for a given year
- r—Discount rate, or the target rate of return on the investment expressed in decimal form
Keep in mind, there are a wide range of formulas used for DCF analysis outside of this simplified one, depending on what type of investment is being analyzed and what financial information is available for it. This formula is simply meant to highlight the general reasoning used in the process.
What is an example of calculating discounted cash flow analysis?
Let’s say you’re looking at buying a 10% stake in a private company. It has an established business model that’s profitable and its revenue is growing at a consistent rate of 5% per year. Last year, it produced $2 million in cash flow, so a 10% stake would’ve likely given you $200,000 had you purchased it last year.
Here’s a simplified explanation of how DCF analysis could help you determine how much you should reasonably pay for that 10% stake:
This year, the business would give you $210,000, assuming the company’s established 5% YoY revenue growth. Next year, $220,500, and so on, assuming the company’s growth rate stays consistent.
Let’s also assume your target compound rate of return is 14%—that is to say, the rate of return you know you can likely achieve on other investments. This means you wouldn’t want to purchase the stake in the business unless you knew you could achieve at least that rate of return; otherwise, you’re better off investing your money elsewhere. Because of this, 14% becomes the discount rate (r) you apply to all future cash flows for the prospective investment.
The numerators in the equation above represent the expected annual cash flows, assuming a 5% YoY growth rate. Meanwhile, the denominators convert those cash flows into their present value since they’re divided by your target 14% annual compound interest. The DCF is the sum of all future cash flows and is the most you should pay for the stake in the company if you want to realize at least 14% annualized returns over whatever time period you choose.
For the sake of simplicity, let’s say you’re only looking out three years for this investment. The table below illustrates how in this example, even as the expected cash flows of the company keep growing, the discounted cash flows will shrink over time. That’s because the discount rate is higher than the growth rate—meaning you’d make more money on your investment elsewhere, provided you were certain you could reach your target rate of return through other means.
|Year||Cash flow||Discounted cash flow|
In this scenario, even though you’d hypothetically receive $231,525 in cash flow in year three of your investment, that would only be worth $156,273 to you today. Reason: If you invested that same amount today and realized a 14% YoY return on it through another investment, you would have turned it into $231,525 in that same time period. And because the discount rate (14%) is higher than the growth rate of the company’s cash flow (5%), the discounted versions of those future cash flows will continue to decrease in value each year until they reach zero.
Assuming your target YoY rate of return is 14% for this investment and your exit window is three years out, $510,151—the total DCF for that time period—is the most you should pay for the 10% stake at this time.
DCF vs comparables: When should you use each approach?Calculating discounted cash flow analysis is just one approach to calculating valuations. Building comparables and an accurate peer group is another. The widely accepted way to arrive at a valuation for a company combines a series of the three models: private comps, public comps and discounted cash flow analysis.
DCF analysis will make it clearer how long it might take to see a certain level of return, whereas a comparable gives better insight into the mood of the market. Finding the inputs for a DCF analysis can also be more difficult than a comps analysis if you don’t have a trusted data source.
How to save time on your next company valuationAccurately valuing a private company requires insight into the flow of capital across the entire venture capital, private equity and M&A landscape—not to mention the public markets. The process can take up a lot of valuable analyst time, especially if your firm uses legacy valuation tools and data that live on different systems.
Integrating a tool like PitchBook into your workflow means you have access to the world’s largest database of multiples and valuations as well as a suite of tools designed specifically to help you to work more efficiently.
We know that along with accuracy, speed is essential when building financial models. A thoroughly vetted transaction or company comparable analysis won’t do you much good if your target signs with someone else while you’re doing it.
PitchBook lets you build financial models in a matter of minutes. By allowing you to quickly identify different types of funding rounds, companies and financings, PitchBook enables you to seamlessly navigate between datasets to find relevant transactions fast.
Find out how PitchBook can help simplify your valuation workflow by checking out our full suite of valuation tools.
Update: This article originally had a calculation error that has been corrected