Understanding DCF Models

Discounted Cash Flow (DCF) analysis is a powerful valuation method used to estimate the value of an investment based on its expected future cash flows.

What is a DCF Model?

A DCF model is a financial valuation tool that projects and discounts future cash flows to arrive at a present value estimate. This value is then used to evaluate the potential for investment.

Key Components of a DCF Model

1. Projected Free Cash Flows: Estimating future cash flows the company will generate.
2. Discount Rate: Typically the Weighted Average Cost of Capital (WACC).
3. Terminal Value: The estimated value of the company beyond the forecast period.

Steps in Creating a DCF Model

1. Forecast free cash flows for 5-10 years
2. Calculate the discount rate
3. Estimate the terminal value
4. Discount all future cash flows to present value
5. Sum the present values to get the estimated intrinsic value

Advantages and Limitations

Advantages:

• Considers time value of money
• Focuses on cash flow, not just earnings

Limitations:

• Highly sensitive to inputs and assumptions
• Can be complex and time-consuming

In future posts, we'll walk through creating a DCF model step-by-step and discuss advanced techniques for refining your models.