Valuation using discounted cash flows

Example<table><tbody><tr><td colspan="6">MedICT is a medical <a href="/facts/Information_and_communications_technology/wG6q8RfN">ICT</a> startup that has just finished its business plan. Its goal is to provide medical professionals with bookkeeping software.<p>Its only investor is required to wait for five years before making an exit. Therefore, MedICT is using a forecast period of 5 years.</p><p>The forward discount rates for each year have been chosen based on the increasing maturity of the company. Only <a href="/facts/Operating_cash_flow/6VgDq1yJ">operational cash flows</a> (i.e. <a href="/facts/Free_cash_flow_to_firm/W4IwHvwr">free cash flow to firm</a>) have been used to determine the estimated yearly cash flow, which is assumed to occur at the end of each year (which is unrealistic especially for the year 1 cash flow; see comments aside). Figures are in $thousands:</p></td></tr><tr><th>Cash flows</th><th>Year 1</th><th>Year 2</th><th>Year 3</th><th>Year 4</th><th>Year 5</th></tr><tr><td>Revenues</td><td>+30</td><td>+100</td><td>+160</td><td>+330</td><td>+460</td></tr><tr><td>Personnel</td><td>−30</td><td>−80</td><td>−110</td><td>−160</td><td>−200</td></tr><tr><td>Car Lease</td><td>−6</td><td>−12</td><td>−12</td><td>−18</td><td>−18</td></tr><tr><td>Marketing</td><td>−10</td><td>−10</td><td>−10</td><td>−25</td><td>−30</td></tr><tr><td>IT</td><td>−20</td><td>−20</td><td>−20</td><td>−25</td><td>−30</td></tr><tr><td>Total</td><td>-36</td><td>-22</td><td>+8</td><td>+102</td><td>+182</td></tr><tr><td>Risk Group</td><td>Seeking Money</td><td colspan="2">Early Startup</td><td>Late Start Up</td><td>Mature</td></tr><tr><th>Forward Discount Rate</th><th>60%</th><th>40%</th><th>30%</th><th>25%</th><th>20%</th></tr><tr><th>Discount Factor</th><th>0.625</th><th>0.446</th><th>0.343</th><th>0.275</th><th>0.229</th></tr><tr><td>Discounted Cash Flow</td><td>(22)</td><td>(10)</td><td>3</td><td>28</td><td>42</td></tr><tr><td colspan="6">This gives a total value of 41 for the first five years' cash flows.</td></tr><tr><td colspan="6">MedICT has chosen the perpetuity growth model to calculate the value of cash flows beyond the forecast period. They estimate that they will grow at about 6% for the rest of these years (this is extremely prudent given that they grew by 78% in year 5), and they assume a forward discount rate of 15% for beyond year 5. The terminal value is hence:<p>(182*1.06 / (0.15–0.06)) × 0.229 = 491.</p><p>(Given that this is far bigger than the value for the first 5 years, it is suggested that the initial forecast period of 5 years is not long enough, and more time will be required for the company to reach maturity; although see discussion in article.)</p><p>MedICT does not have any debt so all that is required is to add together the present value of the explicitly forecast cash flows (41) and the continuing value (491), giving an equity value of $532,000. </p></td></tr></tbody></table>
<p>Valuation using discounted cash flows (DCF valuation) is a method of estimating the current value of a company based on projected future <a href="/facts/Cash_flow/TM2tHnlW">cash flows</a> adjusted for the <a href="/facts/Time_value_of_money/5P6w8SAr">time value of money</a>.
The cash flows are made up of those within the “explicit” <a href="/facts/Forecast_period_(finance)/LuKU6Bnf">forecast period</a>, together with a continuing or <a href="/facts/Terminal_value_(finance)/NXRdqxW3">terminal value</a> that represents the cash flow stream after the forecast period.
In several contexts, DCF valuation is referred to as <a href="/facts/Business_valuation/Fslwea3l">the "income approach"</a>.
</p><p>Discounted cash flow valuation was used in industry as early as the 1700s or 1800s; it was explicated by <a href="/facts/John_Burr_Williams/4pBcScJ1">John Burr Williams</a> in his <i><a href="/facts/The_Theory_of_Investment_Value/4pBcScJ1">The Theory of Investment Value</a></i> in 1938; it was widely discussed in <a href="/facts/Financial_economics/oraavYoW">financial economics</a> in the 1960s; and became widely used in U.S. courts in the 1980s and 1990s.
</p><p>This article details the mechanics of the valuation, via a worked example; it also discusses modifications typical for <a href="/facts/Startup/9lsjFELt">startups</a>, <a href="/facts/Private_equity/DpqoqjBH">private equity</a> and <a href="/facts/Venture_capital/yeH3m7zo">venture capital</a>, <a href="/facts/Corporate_finance/ugQCsFBQ">corporate finance</a> "projects", and <a href="/facts/Mergers_and_acquisitions/YfczSf3M">mergers and acquisitions</a>, and for sector-specific valuations in financial services and mining. See <a href="/facts/Discounted_cash_flow/pm5a7BYj">discounted cash flow</a> for further discussion, and <a href="/facts/Valuation_(finance)/ubVtk8RG">Valuation (finance) § Valuation overview</a> for context.
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Valuation using discounted cash flows open-in-new

Valuation using discounted cash flows