Discounted Cash Flow (DCF)

The Discounted Cash Flow (DCF) method is one of the most important approaches for company valuation. It estimates a company's future cash flows and discounts them to their present value. The core principle is that money available today is worth more than the same amount in the future – a concept known as the time value of money. The DCF method takes into account both the projected income and the risks associated with the business.

The calculation involves several steps:

1. Forecasting future cash flows: Based on the company's revenues, expenses, and investments.
2. Discounting to present value: Using a discount rate (typically the Weighted Average Cost of Capital, WACC) to bring future cash flows to today's value.
3. Calculating the company's value: The sum of the discounted future cash flows represents the company's value.

When is the DCF method used?

The DCF method is primarily used in M&A transactions to determine the fair value of a company. It is particularly suitable for companies with stable and predictable cash flows.

Advantages of the DCF method:

• Takes future income and risks into account.
• Provides a detailed valuation based on real financial data.
• Can be applied to various scenarios (e.g., optimistic or pessimistic projections).

Disadvantages of the DCF method:

• Highly dependent on the assumptions made.
• Projections may be inaccurate, especially in volatile markets.

Example:

An e-commerce company expects the following annual cash flows over the next five years:

• Year 1: €500,000
• Year 2: €600,000
• Year 3: €700,000
• Year 4: €800,000
• Year 5: €900,000

The Weighted Average Cost of Capital (WACC) is 10%. Using the DCF method, the present value of these future cash flows is calculated. The result shows how much the company is worth today based on its future earnings.