Discounted cash flow analysis calculates the present value of a future cash flow stream, which might be uneven, constant or steadily growing at different points in a company's existence. The value of a business is the present value of its cash flows in the projection period, which is usually a few years because you cannot accurately predict too far into the future, and the present value of the residual value. Also known as the terminal value, it is the present value of the cash flow streams after the terminal year, which is the last year of the projection period.
Cash Flow Projection
Get the net income for the year, which is equal to sales minus operating expenses, interest and taxes.
Add back depreciation expenses because it is a non-cash expense. Depreciation is the allocation of a fixed asset's cost over its useful life.
Adjust for changes in working capital from the previous year. Subtract a positive change and add a negative change in working capital, which is the difference between current assets and current liabilities.
Deduct planned capital expenditures, such as renovations and maintenance, to get the cash flow projection for each year.
Estimate the cash flow growth rate for each year in the projection period. You may use your historical growth rates or the industry growth rates for your projections. You may also estimate the growth rates for the revenue and expense items separately, and then calculate the annual cash flow.
Determine a discount rate for the discounted cash flow analysis. New York University professor Ian H. Giddy suggests that this rate should reflect the business and investment risks. Choose a rate that falls somewhere between the cost of borrowing and the rate of return that equity investors expect, which could be the average return on a major market index, such as the Dow Jones Industrial Average.
Calculate the terminal value at the end of the projection period. It is the present value of the cash flow stream after the terminal year, which is the last year of the projection period. For a constantly growing cash flow into perpetuity, the residual value is [CF (1 + g)] / (r - g), where "CF" is the cash flow in the terminal year, "r" is the discount rate and "g" is the cash flow growth rate. For a constant cash flow, the formula simplifies to CF / r because "g" is zero. For example, if the cash flow in the terminal year is $1,000, the discount rate is 5 percent and the growth rate is 2 percent, then the residual value is [$1,000 (1 + 0.02)] / (0.05 - 0.02), or $34,000.
Compute the present value of the terminal value by discounting it back to the present. The regular present value formula is CF / (1 + r)^t, where "CF" is the cash flow in year "t." To conclude the example, if the terminal year is five, the present value of the residual value is about $26,640 [$34,000 / (1 + 0.05)^5 = $34,000 / 1.05^5 = $26,640].