The DCF is among the most widely used valuation methodologies in finance. It gives you an estimate of the intrinsic value of an entity given a set of assumptions (that mainly based and drive future cash flows) but when it comes to valuation, you shouldn’t use only one method but you should use more than one method.
In this post, I will explain the main steps if you would like to do valuation using DCF.
STEP 1: you need to decide on What kind of cash flows will you be discounting - unlevered or levered free cash flows? Are these enterprise value (before debt payments) or equity value (after debt payments) FCFs? (more information and details about these terms will be produced in short video tutorials and case studies to help you understand these terms, please follow the Financeer to be updated with all new tutorials).
Discounting unlevered FCFs will yield the enterprise value, while discounting levered cash flows will yield equity value. It's pretty easy to get from equity value to enterprise value and vice versa, so both approaches theoretically get you to the same result, but in reality the majority of the DCFs you'll create will be unlevered DCFs, so that's what we'll use in our illustration.
STEP 2: Figure out how many stages you want your DCF to be. Most practitioners who value mature companies use a two-stage DCF model.
In stage 1, you forecast cash flows explicitly for a certain period (usually 5-10 years) and in stage 2 you will need to calculate the terminal value. Let's assume a two-stage DCF (again, most prevalent model).
STEP 3: Discount the stage 1 cash flows by an appropriate discount rate that reflects the riskiness of the capital. For unlevered DCF, use WACC as the discount rate... for a levered DCF, use cost of equity as the discount rate (as you already eliminated the impact of debt).
STEP 4: Calculate stage 2 FCF (terminal value) using growth in perpetuity method or exit EBITDA multiple method or the average of both.
STEP 5: Discount stage 2 back to the present using the same discount rate you used in step 3.
STEP 6: Since we are doing an enterprise value DCF, the enterprise value is the sum of stage 1 + stage 2 discounted cash flows which calculated in steps 4 and 5.
Now you are done with your enterprise value.
STEP 7: Calculate the equity value
STEP 8: calculate the intrinsic value per share and this will give an indication of whether the market price is overvalued or undervalued.
STEP 9: Usually when it comes to valuation we are using several other methods such as multiples for comps or precedents and then we put all results of stock value in one sheet to decide on the value we will start the negotiation on.