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What is DCF Value?

We buy most assets because we expect them to generate cash flows for us in the future. In discounted cash flow valuation, we begin with a simple proposition: The value of an asset is a function of the expected cash flows on that asset. Put simply, assets with high and predictable cash flows should have higher values than assets with low and volatile cash flows.

How DCF valuation works

The discounted cash flow valuation method is based on the concept of the time value of money, which says that money in the future is not worth as much as that same money today.

To calculate what a certain amount of money is worth in the future, you have to discount it, or account for the fact that you lost the chance to invest it and earn money from it. Hence, why it is called the discounted cash flow method.

To illustrate the point, let’s say that a company made $10,000 today. That $10,000 today is worth more than $10,000 a year from now, or five years from now. That’s because it could invest today’s $10,000 and earn interest that would increase the total amount after a year. At an interest rate of 5%, in a year that $10,000 would grow to be worth $10,500. Obviously, $10,500 is worth more than $10,000.

Thus, to calculate the DCF value of a company, we forecast its future cash flows and discount them at a rate that reflects the riskiness of those cash flows.

How DCF value calculated

To calculate DCF value, we need to estimate future cash flows and select an appropriate discount rate.

Free cash flow forecasting

We have several operating models that we use to arrive at a company’s free cash flow. Which model will be used is determined by our algorithm and is based on the characteristics of the company being valued.

When predicting the inputs (such as revenue, capital expenditures, working capital, margins, etc.) required to calculate cash flow, we take into account:

  • Historical performance. We use regression models to predict future values based on historical data.
  • Base rates. We take into account how companies in the industry have historically behaved in similar situations (with the same growth in revenue, margins, etc.).
  • Analyst estimates. Forecasts of the company’s financial performance by Wall Street analysts as well as analyst estimates for companies in the industry.

Discount rate calculating

Alpha Spread analyzes risk-free rates, capital ratios, interest coverage ratios, and risk premiums to calculate the WACC/Discount Rate used within our models.

The bottom line

With DCF, the value of an asset is the present value of its expected future cash flows, discounted using a rate that reflects the risk associated with the investment. To determine DCF, you need to estimate future cash flows and select an appropriate discount rate.

Alpha Spread uses a proprietary algorithm to forecast future free cash flow and an appropriate discount rate.

Updated on May 5, 2022

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