Introduction to DCF Valuations

Introduction to DCF Valuations

Sarah Martin

30 years: Corporate Valuations

In this video, Sarah Martin introduces Discounted Cash Flow (DCF) valuations. She then covers the main advantages and disadvantages of this method. She also touches on key considerations such as terminal value, unlevered free cash flow, and the role of DCF in valuing different types of entities.

In this video, Sarah Martin introduces Discounted Cash Flow (DCF) valuations. She then covers the main advantages and disadvantages of this method. She also touches on key considerations such as terminal value, unlevered free cash flow, and the role of DCF in valuing different types of entities.

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Introduction to DCF Valuations

13 mins 42 secs

Overview

DCF valuations are based on the idea that the present value of a corporate or project is determined by the future cash flows it generates, discounted at a rate reflecting the riskiness of those cash flows. The DCF method proves flexible, accommodating various investment opportunities and detailed assumptions. Advantages include its adaptability to different types of firms, ability to incorporate detailed assumptions, suitability for valuing loss-making entities, and flexibility in scenario analysis. However, drawbacks include challenges in forecasting terminal values, subjectivity in calculating the Weighted Average Cost of Capital (WACC), and susceptibility to assumptions drift. Despite these, DCF remains a powerful valuation method with applications ranging from startups to well-established firms.

Key learning objectives:

  • Understand the advantages of DCF valuations

  • Understand the disadvantages of DCF valuations

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Summary
What are the advantages of using the DCF method?

  1. Its flexibility makes it applicable across a spectrum of investment opportunities, from well-established corporations to innovative startups. 
  2. DCF's strength lies in its capacity to assimilate intricate assumptions and diverse data into the valuation process. This includes meticulous considerations such as revenue forecasts, currency dynamics, detailed cost breakdowns encompassing marketing and research expenses, investment projections, working capital adjustments, and even one-off items like restructuring costs. 
  3. The DCF method stands out in its ability to value firms that might be negative during the valuation year, including startups. Unlike traditional multiples, which may falter in such scenarios, DCF accommodates the valuation by factoring in anticipated future cash flows. 
  4. DCF supports robust scenario analysis, enabling analysts to explore how valuations would evolve under varying key assumptions.
  5. DCF liberates itself from the need for a comparable group of companies. While traditional valuation methods may rely on the valuation multiples of comparable firms, DCF provides an absolute valuation for an investment opportunity. 

 What are the drawbacks of DCF valuations?

  1. Forecasting a terminal value five or ten years into the future poses a substantial difficulty. The Weighted Average Cost of Capital (WACC) calculation, introduces an element of subjectivity and difficulty. DCF valuations are highly sensitive to assumptions regarding the terminal value and WACC.  This is particularly noteworthy given that the terminal value often constitutes a significant portion of a corporate DCF valuation like startups.
  2. DCF valuations are susceptible to "assumptions drift, - extrapolating current trends without adequately considering factors such as slowing growth, declining margins, or increased capital spending, potentially leading to overvaluations.
  3. Risk of producing valuations significantly deviating from the actual values of competitor companies or similar investments. This was evident during the period of low interest rates between 2011 and 2019 when artificially low WACCs led to inflated DCF valuations.
  4. DCF valuations may overvalue cyclical firms when the economy heads into a downturn.


  5. DCF method has limitations in reflecting changes in non-cash items or accruals, potentially overlooking shifts in a firm's valuation triggered by non-cash factors.

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Sarah Martin

Sarah Martin

Sarah Martin has a degree in economics from the London School of Economics and stock exchange and regulatory qualifications from London and New York. She has worked in investment banking for 17 years, as well as private equity transactions and as an expert witness in financial trials. She became a financial trainer 15 years ago and specialises in credit, distressed debt, and valuation. Recent assignments have included the European Central Bank, the European Investment Bank, the EBRD, Gibbs Business School in Johannesburg, the Bahrain Institute of Business Finance, the Bank of China, BBVA, the African Development Bank, Siemens, Carnegie Bank, Rand Merchant Bank, the Hamburg Central Bank, and Mizuho Bank.

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