DCF - Company Valuation Using the Discounted Cash Flow Method

The Discounted Cash Flow method is a proven technique for determining a company's value. It is typically used when a company is being sold.

Because in a company sale, it is always a key concern for both the seller and the buyer to achieve a price that accurately reflects the company's value. But what is the "correct" company value? The value of a company can usually be determined using appropriate valuation methods.

A common method for this is the so-called Discounted Cash Flow method - or DCF method for short. Learn everything you need to know about this method here. Our experienced M&A analyst answers the most frequently asked questions about the topic: What is the DCF method? What variants of the Discounted Cash Flow method are there? When is the equity approach used, and when is the entity approach used? Read on!

What is the DCF method?

The Discounted Cash Flow method is an investment theory-based method and a way to determine a company's value. "Discounted Cash Flow" - abbreviated as DCF - translates to "discounted cash flow."

Therefore, in the DCF method, expected future cash surpluses are initially discounted to their present value. The calculated values are then summed up to ultimately determine the current company value, known as the capital value or present value.

DCF Method is Not Just One Method

In the Discounted Cash Flow method, two variants are distinguished:

1. Entity Method
2. Equity Method

In the Entity Method, three different interest rate concepts play a role:

WACC Approach
TCF Approach
APV Approach

When was the DCF method recognized by the IDW?

The DCF method has long been prevalent in the Anglo-Saxon world, while in Germany, the earnings value method was traditionally preferred. However, both methods have many similarities.

The DCF method is increasingly gaining acceptance in Germany, partly due to the growing internationalization of company sales. The renowned Institute of Public Auditors in Germany (IDW) has recognized the DCF method with IDW Standard S1 around the year 2000, equating it with the earnings value method as a valuation method. This is, in effect, the "license" for its application in Germany.

What are the challenges of the Discounted Cash Flow method?

Three major difficulties in using the DCF method are:

The estimation of exact future cash flows The inclusion of (future) tax burdens Determining the discount rate used to discount future cash flows In this article, we will address these three points to facilitate the application of the DCF method and clarify any uncertainties.

The DCF Method as a Comprehensive Valuation Method

In the context of company valuation methods, a distinction is made between:

Comprehensive valuation methods Individual valuation methods Mixed methods The DCF method and its various calculation approaches are among the comprehensive valuation methods.

Here, the company is not evaluated as the sum of individual economic assets but rather as a comprehensive valuation unit. The company's value is thus derived from its future earning power.

Since the DCF method mainly focuses on the future development of company earnings, it can be categorized within the comprehensive valuation methods as a future income value method.

What are the differences between the earnings value method and the DCF method?

In addition to the DCF method, the earnings value method is also one of the capital value-oriented comprehensive valuation methods. Both methods share the basic idea that a company's value is not determined by its current substance but by the future benefits that shareholders can expect from their ownership.

A company is thus worth as much as these benefits are worth today.

While the earnings value method is based on future profits, the DCF method is based on future cash surpluses (cash flow). These two metrics are not necessarily identical and do not necessarily match periodically.

To determine the present value, both methods discount future benefits, known as Discounted Cash Flow in the DCF method, and sum them up.

What is the advantage of the Discounted Cash Flow method?

From an investment theory perspective, the DCF method is the "cleaner" method because, ultimately, what matters to investors are the cash returns from investments, not the earnings. Additionally, the cash flow is less susceptible to accounting manipulation than accounting profit, making it more objective.

Discounted Cash Flow Method: Two Calculation Methods

There are two approaches to determining company value using the DCF method:

Gross capitalization (Entity Method) Net capitalization (Equity Method) The two methods mainly differ in how they tax-deduct the differences between equity and debt capital to determine the value of equity.

The Entity Method (Gross Capitalization) in the Discounted Cash Flow Method

In the Entity Method, the total company value is first determined. The market value of the debt capital is then subtracted. The remaining market value of equity represents the "actual" company value of interest to the owners.

The basis of the calculation is the Free Cash Flow. This is, simply put, the periodic cash surplus from operational business activities plus interest minus expenditures for investments.

The Equity Method (Net Capitalization) in the Discounted Cash Flow Method

The Equity Method essentially consists of only one step. In this approach, the cash flow already accounts for the interest on loans. Only the cash surpluses available to the owners are considered. Consequently, the determined company value automatically represents the market value of the equity.

Whether using the Entity or Equity Method, the challenge in both approaches lies in accurately estimating future (Free) Cash Flows. This is done using corresponding planning calculations, which naturally involve a degree of uncertainty.

The Importance of Discounting and Various Interest Rate Concepts

What does discounting mean in the context of company valuation using DCF? The selected discount rate has a significant impact on the company value. The higher the discount rate, the lower the company value and vice versa. Therefore, correct discounting is a crucial task.

In the Equity Method/Net Capitalization, discounting is inherently done using the cost of equity. This approach ultimately incorporates the concept of opportunity cost, supplemented by a premium for the assumed risk.

In the Entity Method/Gross Capitalization, three interest rate concepts are applied:

1. The WACC Approach

In the WACC approach (WACC = Weighted Average Cost of Capital), the discount rate is calculated based on the weighted average cost of capital, corresponding to the shares of equity and debt capital. The cost of equity is determined using the Capital Asset Pricing Model (CAPM) from financial theory. The tax advantage of debt financing (tax deductibility of interest) is accounted for through a correction factor in the cost of debt capital.

2. The TCF Approach

The TCF approach (TCF = Total Cash Flow) is essentially similar to the WACC approach. The difference lies in tax considerations. The tax benefit of debt capital is factored into the Free Cash Flow calculation, eliminating the need for a correction factor in the cost of debt capital.

3. The APV Approach

In the APV approach (APV = Adjusted Present Value), the company value is first determined under the hypothetical assumption of pure equity financing. The Free Cash Flow is discounted using the cost of equity. The calculated value is then increased by the tax advantage of debt capital, and the market value of the debt capital is subtracted.

Comparing Discounted Cash Flow with Other Methods

In addition to using the DCF method, it may be beneficial to conduct additional company valuations using other methods to provide a broader basis for determining company value. This generally includes the comparable company or multiplier method and/or the asset-based method.

The comparable company or multiplier method is a market value-oriented comprehensive valuation method. The company value can be determined in two ways: it is either derived from the market prices of comparable publicly traded companies or based on the prices at which comparable companies are transacted.

The asset-based method, unlike all previously mentioned valuation methods, falls under individual valuation methods, as it considers the current market values of the individual assets of the company. Thus, all tangible assets, or the substance of the company, are valued.

Overview of Company Valuation Using Discounted Cash Flow

Once you decide to sell your company, the company valuation is an important first step. There are various methods to determine the company value. One of these methods is the DCF method. Due to internationalization, this method is becoming increasingly important and gradually replacing the traditional earnings value method.

In the context of the DCF method for company valuation, two approaches are distinguished: the Entity and the Equity Method. These two approaches mainly differ in how they tax-deduct the differences between equity and debt capital. In this context, it is essential to know the different discounting concepts and understand why correct discounting plays a significant role in company valuation. Low-interest rates have a positive effect on the company value.

Besides the discount rate, several other factors affect the company value. Learn about the factors influencing company valuation in our article.

Have a Company Valuation Conducted Using DCF

If you are looking for experienced, trustworthy, and highly professional M&A experts to whom you can entrust the valuation of your company, you are in the right place with us. Have your company valued for free by one of our succession consultants. Our experts look forward to your inquiry.