Thread by @ICICI_Direct

Here is the next part of our series on Fundamental Analysis📈

Let's learn about Discounting Future Cash Flows & DCF Model of valuation

A thread 🧵👇#LearnwithICICIDirect

[A] What is Discounting?

Discounting is the method of determining present value of future payments/inflows.

It helps us to factor time value of money.

The value of INR 1,00,000 is more today vis-à-vis having the same amount 10 years down the line

[B] What are Cash flows (CF)?

CF are the cash generated by business. CF can be from operating, investing or financing activities

[C] What is a Discounted Cash Flow (DCF) Model?

🔶DCF analyses the value of business based on projections of how much cash that business will generate in future

🔶DCF model can be applied to value a stock, company, project, and many other assets for the purpose of valuation

[D] How to calculate DCF?

Steps to perform DCF exercise:
🔶Forecast the free cash flow (FCF)
🔶Calculate weighted average cost of capital (WACC)
🔶Calculate terminal value (TV)
🔶Discount free cash flow (FCF) & terminal value (TV)
🔶Calculate implied share price

Contd. 👇

[D.1] Forecast FCF

🔶FCF is the cash available for debt and equity holders after the business pays its operating expenses

🔶We should project FCF until they reach a steady state (usually 5-10 years)

Check out the below image for the steps to calculate FCF 👇

[D.2] Calculate WACC

🔶WACC is the average cost of each capital source of the Company
🔶It represents the overall Cost of Capital for the business
🔶It is used as a discount rate for future cash flows in DCF Model

Find below the formula for WACC👇

[D.3] Calculation of TV

🔶It's not practical to assume FCF beyond Nth year

🔶It's value of the Co’s future FCF beyond the Nth year

🔶There are many ways to calculate TV but most commonly known method is to apply perpetual growth rate

Refer below image for calculation of TV 👇

[D.4] Discounted FCF

🔶In this step we’ll calculate present value of FCF using WACC as discount rate

🔶DCF analysis helps in assessing viability of an investment by calculating the present value of expected FCF

Refer to below image👇

[D.5] Calculate Implied Share Price

Value of the Co. as per DCF Model = Sum of PV of Free Cash Flow + PV of terminal Value

Value per Share = Value of the Company /No. of shares

Through this DCF model helps us calculating fair value per share

[E] How is it used?

🔶To determine the fair value of an investment
🔶Help business owners make budget and investment decisions
🔶Help users account for different projections that might be possible
🔶Also facilitates Sensitivity Analysis

[F] Limitations of the DCF Model

🔶DCF analysis involves estimates, not the actual figures
🔶FCF depends on no. of factors, such as market demand, technology, unforeseen threats etc. These can't be quantified precisely
🔶It involves Complex analysis

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TL;DR

[1] What is discounting
[2] What is Cash Flow
[3] What is DCF Model
[4] Steps to calculate value of Co. using DCF
[5] Uses of DCF Model
[6] Limitations of DCF Model

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