The discounted cash flow, or intrinsic valuation method, is the method used to measure the realizable value of an investment. It is a valuation method based on projecting all future cash flows generated by the company's operations and discounting them by the return required by investors.
To calculate the company's future cash flows, historical financial data (balance sheet, P&L and cash flow) for the last few years are used, and realistic assumptions are made based on the expected growth of the company and the performance of the sector.
It is therefore essential to have expert valuers who know the sector in order to be as realistic as possible. Otherwise this "objective" valuation would become a simple mathematical fiction with no real value. The key to this valuation method is the analyst's ability and experience in similar operations.
In the case of discounted cash flows, the longer these flows are projected, the more difficult it will be to get close to what will really happen, since the assumptions will no longer be as accurate. This is why normally, depending on the industry and the life cycle of the company, we will look to project cash flow generation between 5 and 10 years.
Once the first 5 or 10 years have been projected, we will proceed to simulate the rest of the cash flows, and we will group them under the name of "Terminal Value".
How to calculate the shareholder's required return (Ke)
The rate at which projected cash flows must be discounted is the shareholder's required return, which is neither the expected return nor the historical return. Therefore, this rate will be different for each investor depending on his risk aversion.
It is important to note that the flows to be discounted by the return demanded by the shareholders must be the free cash flows for the shareholder (after investments and financing).
A practical way to calculate is as follows: Re=Rf+Rp, where
How to calculate terminal value
To calculate the terminal value in the discounted cash flow valuation, there are two different ways which have to be applied in different cases:
This method assumes that the company will grow reasonably for an infinite period of time and that the return on investment will be greater than the required return.
To do this, the first step is to see in which economic cycle the sector in which it operates, the company and its products are located and then analyze what sustainable growth it can have in the future.
This method assumes that industry multiples are good indicators of the real value of the company, so first a universe of comparable companies is sought. Then we look for the variables that really influence the value of the company by means of a multivariate analysis. The value of the different companies selected is then divided by these variables and the median is calculated. Finally, we usually multiply the median we have calculated by the value of this variable of our company.
For example: Let's imagine that we are analyzing an industrial company, we have already made an analysis of the companies in the sector or complementary sectors and we have chosen the companies that are best comparable. We have found that EBITDA is the variable that has the strongest relationship with the value of the companies. We have also calculated the median and it gives us that the companies have a median of 8 times their EBITDA, so we would multiply the EBITDA of our company by 8, thus obtaining the terminal value of the company.
In order to calculate the terminal value using exit multiples, it is essential to have knowledge of the sector in which the company operates, market development and the ability to find the variables that are really related to the final valuation, since in many sectors, such as the technology sector, EBITDA multiples can distort the final valuation and wrongly undervalue or overvalue the real valuation of the company. In other words, it is necessary to use multiples that really influence the valuation of the company, which differs in each sector or economic cycle that the company is going through.
The sum of the discounted cash flows and the terminal value would be the intrinsic value of the company.
Example of discounted cash flow valuation
In the following example we can see in a very simplified way how the discounted cash flow valuation works, in this case we would apply a required rate of return of 10%.
The limitations that this methodology may have is the difficulty of finding realistic assumptions, which implies the need to be advised by an expert to avoid a meaningless valuation, which would only lead to meaningless investment or disinvestment decisions.
It is also a method that does not take into account the economic cycle and the possible revaluation or boom of certain sectors, which is why this method must be supported by the multiples method to achieve a realistic and objective range.