What is a Discounted Cash Flow (DCF): Free Cash Flow, Terminal Value, and Discount Rate (WACC) explained for your financial planning

The Discounted Cash Flow (DCF) method is one of the most popular and reliable approaches for valuing a company. It helps investors determine the present value of a company based on its expected future cash flows. The DCF model is widely used in finance to assess the intrinsic value of a business, making it a critical tool for analysts, investors, and business owners.

In this guide, we will break down the key components of the DCF model: Free Cash Flow (FCF), Terminal Value (TV), and the Discount Rate (WACC). We will explain these concepts in simple terms and walk through an example to help you apply them effectively.

What is the Discounted Cash Flow (DCF) Method?

The Discounted Cash Flow (DCF) method values a company by estimating the future free cash flows (FCF) it will generate, and then discounting them back to the present value using an appropriate discount rate. Essentially, it’s a way of saying, “What is the value of all the future cash a company will generate, adjusted for the time value of money?”

The DCF model relies on three key components:

1. Free Cash Flow (FCF)
2. Terminal Value (TV)
3. Discount Rate (WACC)

Together, these components help estimate the present value of a company, which investors can use to assess whether the company is overvalued or undervalued.

1. Free Cash Flow (FCF): What is the Company Actually Earning?

What is Free Cash Flow (FCF)?
Free Cash Flow (FCF) represents the cash a company generates after accounting for capital expenditures (CapEx), which are investments in the business like property, equipment, or other assets. FCF is important because it shows how much cash the company has left to reinvest in its operations, pay dividends, or reduce debt. In essence, FCF reflects the money available to shareholders after the company has reinvested in its growth.

Formula:

• FCF = Operating Cash Flow - Capital Expenditures (CapEx)

Where:

• Operating Cash Flow is the cash generated from normal business operations (found on the cash flow statement).
• CapEx represents the cash used for purchasing or maintaining fixed assets, like equipment and buildings.

Example:
Let’s assume TechGuru, a tech company, has the following financials:

• Operating Cash Flow = INR 10,000,000
• Capital Expenditures (CapEx) = INR 3,000,000

Now, calculate the Free Cash Flow:

• FCF = INR 10,000,000 - INR 3,000,000 = INR 7,000,000

This means that after investing in its growth, TechGuru has INR 7,000,000 in free cash flow available for debt payments, dividends, or reinvestment.

Why It Matters:
FCF is a key indicator of a company’s financial health because it shows how much cash is available to create value for investors. A positive and growing FCF suggests that the company is generating more than enough cash to fund its operations, while a declining FCF might signal financial trouble.

2. Terminal Value (TV): Estimating Future Value Beyond the Projection Period

What is Terminal Value?
The Terminal Value (TV) accounts for the value of a company’s cash flows beyond the projection period (typically 5–10 years). Since it’s difficult to predict a company’s cash flows indefinitely, the terminal value estimates the company’s future value at the end of the projection period. It’s typically calculated using one of two methods:

1. Perpetuity Growth Method (Gordon Growth Model): This method assumes the company’s free cash flow will grow at a constant rate forever.
2. Exit Multiple Method: This method estimates the company’s terminal value based on a multiple of its financial metric (e.g., EBITDA, EBIT, or revenue).

Formula (Perpetuity Growth Method):

• TV = FCF in Final Year × (1 + g) / (r - g)

Where:

• g = Growth rate of FCF after the projection period.
• r = Discount rate (or WACC).
• FCF in Final Year = Free Cash Flow in the last year of the projection period.

Example:
Let’s assume TechGuru has projected its Free Cash Flow to be INR 7,000,000 in year 5, and it expects a constant growth rate of 5% (g) for FCF beyond year 5. The company’s discount rate (WACC) is 10% (r).

• TV = INR 7,000,000 × (1 + 0.05) / (0.10 - 0.05) = INR 7,000,000 × 1.05 / 0.05 = INR 147,000,000

So, the terminal value at the end of year 5 is INR 147,000,000.

Why It Matters:
The terminal value accounts for the majority of the DCF valuation, especially for companies with long-term growth potential. A higher growth rate or a lower discount rate can significantly impact the terminal value and, therefore, the entire valuation.

3. Discount Rate (WACC): How Much Do You Need to Pay for Future Cash Flows?

What is the Discount Rate (WACC)?
The Discount Rate is used to discount the future free cash flows and terminal value back to the present value. In the DCF model, the discount rate is usually the Weighted Average Cost of Capital (WACC), which represents the company’s cost of capital, weighted by the proportion of debt and equity in the company’s capital structure.

Formula (WACC):

• WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc)

Where:

• E/V = Proportion of equity in the capital structure.
• D/V = Proportion of debt in the capital structure.
• Re = Cost of equity (the return required by equity investors).
• Rd = Cost of debt (the return required by debt holders).
• Tc = Corporate tax rate.

Example:
Let’s assume TechGuru has the following:

• Equity Value (E) = INR 50,000,000
• Debt Value (D) = INR 30,000,000
• Cost of Equity (Re) = 12%
• Cost of Debt (Rd) = 6%
• Tax Rate (Tc) = 30%

Now, let’s calculate the WACC:

• WACC = (50,000,000 / 80,000,000) × 0.12 + (30,000,000 / 80,000,000) × 0.06 × (1 - 0.30)
• WACC = 0.625 × 0.12 + 0.375 × 0.06 × 0.70
• WACC = 0.075 + 0.01575 = 0.09075 or 9.08%

So, the WACC for TechGuru is 9.08%. This will be the discount rate used to bring the future cash flows and terminal value to their present value.

Why It Matters:
The discount rate (WACC) is a critical factor in the DCF model because it determines the present value of future cash flows. A higher WACC results in a lower present value, while a lower WACC increases the present value. The WACC reflects the company’s capital costs and investor expectations for returns, making it crucial for an accurate valuation.

Putting It All Together: DCF Calculation

Now that we have an understanding of the key components, let’s walk through a simplified DCF calculation:

1. Project Free Cash Flow (FCF) for the next 5 years. Let’s assume TechGuru has the following projected FCF:

   • Year 1: INR 7,000,000
   • Year 2: INR 7,350,000 (growth of 5%)
   • Year 3: INR 7,717,500
   • Year 4: INR 8,103,375
   • Year 5: INR 8,508,544

2. Calculate the Terminal Value (TV) using the Perpetuity Growth Method. Based on the above example, the terminal value at the end of Year 5 is INR 218,969,882.
3. Discount the FCF and Terminal Value to their present value using the WACC of 9.08%. The formula for present value is:

   • Present Value = Future Value / (1 + WACC) ^ Year

So, the present value of FCF for Year 1 would be:

• PV(FCF Year 1) = INR 7,000,000 / (1 + 0.0908) ^ 1 = INR 6,417,308

Similarly, calculate the present values for Year 2 to Year 5 and the Terminal Value.

4. Sum the Present Values of all the FCF and Terminal Value to get the total enterprise value.

Happy investing!