How to build a Discounted Cash Flow (DCF) model

A discounted cashflow model (DCF) is one of the most commonly used models to value a company. DCF models are generally created by investors or analysts to determine if the company’s stock is overvalued or undervalued at its current market price.

How a DCF model works?

The key principle behind a DCF model is that the current value of a company can be determined using its future cash flows. The investor, using some methodology, arrives at the future cash flows of the company for the next 5-10 years, and then discounts these cash flows to the present time using a discount rate commonly referred to as weighted average cost of capital (WACC). These future cash flows are of two types: the expected cashflows to the shareholders (dividends) and the free cash flow to equity. Depending on the type of the company and other factors, the investor will choose to project one of these types of cash flows for their DCF model.

What we receive from the DCF model is the present value of the stock that represents the intrinsic value of the company. If the market price of the stock is above this intrinsic value, the stock is said to be overvalued, and if the market price is below this intrinsic value, the stock is said to be undervalued. Based on this, the analyst or the investor can base their BUY/SELL/HOLD decision.

What factors are used for calculating the future cash flows?

One of the most important parts of a DCF models is the quality of projected cash flows. No one knows for certain what a company’s future cash flows will be. Investors make use of a variety of publicly available information about the company, including their historical financial statements, industry trends, competitive analysis, macroeconomic conditions, job market, and other such factors to arrive at the future cash flows. In a way, they arrive at projected revenue, capital expenditure, earnings, and finally free cash flows for the next few years. Investors can also make use of datasets available such as FactSet which aggregates data from various sources including the projected financial statements from various analyst reports.

What is the formula for free cash flows?

The free cash flows can be arrived in different ways. Two methods are described below:

Using EBIT

One way to calculate free cash flows is using Earnings Before Interest and Taxes (EBIT).

We first arrive at EBIT by subtracting Operating Expenses from Revenue.