A discounted cash flow (DCF) is a valuation formula often calculated during the due diligence process of an M&A. It helps businesses understand the present value of a potential investment by enabling them to compare different transactions and determine whether an investment or M&A transaction is suitable for them. Although this cash flow method requires many details, when done correctly it can provide potential buyers with insights into a company’s or investment’s present value and forecasted cash return.
What Is a Discounted Cash Flow?
A DCF is an analytical method used to estimate the value of an investment by discounting its expected or estimated future cash flows. The goal of the DCF analysis is to understand the importance of an investment today based on the forecasted money it will generate. The DCF analysis applies to investments in stock, security, project, asset, or company and is widely used in M&A transactions and inorganic growth strategies.
How Does a Discounted Cash Flow Work?
A DCF analysis is the best way to understand how much an investment is worth. The cash flow method forecasts a company’s future cash flows and discounts them to the present to arrive at its current value. These cash flow models can help prospective buyers understand a company’s present market value.
The formula for the discounted cash flow analysis model is the following: DCF=(CF/(1+r)^1)+(CF/(1+r)^2)+(CF/(1+r)^3+…+(CF/(1+r)^n)
In a nutshell, DCF is the sum of all future discounted cash flows that investment is forecasted to generate. “CF” represents the cash flow for a given year, and “r” is the rate at which the target investment is discounted in decimal form.
Depending on the type of investment being analyzed and the financial information available, the DCF formula can vary. Although companies can use different formulas for DCF analysis, this is the simplified and general one that is used. However, all DCF models require a significant amount of information and detail, all major assumptions about the investment, and future expectations of a business or investment.
How Can Companies Leverage the Discounted Cash Flow Model?
Companies can leverage the DCF model to understand how much an investment is worth. To conduct a DCF analysis, prospective buyers must consider the following:
- the net income after tax.
- assumptions about a variety of factors on a company’s projected sales growth and profit margins.
- the interest rate of the initial investment.
- the cost of capital.
- any potential risks that a company may take on.
As previously noted, the DCF model requires a significant amount of detail and information about the company and investment. The more information and insight into a company’s financials, the simpler it is to analyze the DCF. The analysis is crucial in the decision-making process. Businesses can identify how much an investment is worth, compare different assets, and understand which deals are worth the investment.
How Can a DCF Be Applied in an M&A Transaction?
In a corporate M&A, the DCF approach is often part of the due diligence process by determining the company’s value by computing the current cash flows over the company’s life. The DCF analysis consists of two parts: a forecast period and a terminal value. The forecast period is when the firm exceeds required returns, while the terminal value is the value of the company derived from free cash flows after the forecast period. By understanding a company valuation in an M&A setting, the acquirer in the transaction will be able to make better-informed decisions on whether to bid, negotiate, or let the target firm go.
Inorganic growth corporate strategies result from companies using M&As. In an inorganic growth strategy, there is income-based valuation and market-based valuation. However, income-based valuation is more commonly used to determine a value based on projected future cash flows or earnings.
What Are the Pros and Cons of a Discounted Cash Flow Analysis?
The discounted cash flow analysis comes with advantages and disadvantages. The main advantages are its use of precise numbers and that it provides details on the value of an investment.
The main advantages of a DCF include the following:
- The DCF analysis is extremely detailed, as it uses specific numbers like cash flow projections, growth rate, interest and other measures.
- It considers long-term values by assessing the earnings of an investment over its life value.
- It enables comparison between different companies or investments to arrive at a consistent valuation for them.
- It informs company leaders in an M&A transaction to determine whether a company should merge with or acquire another company.
The main disadvantages of a DCF include the following:
- Performing a DCF analysis requires a significant amount of data and financial information, such as projections for cash flow and capital expenses over several years. Gathering all of the data can take a lot of time.
- Accurate estimates are needed for an accurate analysis.
- The analysis can become very complex because so much data is needed to compute it.
- The analysis is based on future projections of cash flow, so it can result in overconfidence.
Are there tools to Facilitate DCF for M&As or Inorganic Growth?
DCF analysis can help potential buyers make better-informed decisions, the details required, the parties involved in the transactions, and the assumptions that must be made are just a few things that make a DCF extremely complicated.
Most DCF analysis is done using Excel and requires many documents that can take hours for a prospective buyer to manually sift through, given each detail. A virtual data room (VDR) provides a solution through cloud data storage and management. VDRs keep data in one secure place and enable documents to be shared easily between verified parties through all phases of M&A transactions.
Because of the sensitivity of the documents involved in an M&A, it’s crucial for a VDR to have the security measures that will protect data privacy and storage. Additionally, VDR tools should easily integrate into a company’s existing workflows and operating systems so that corporations do not need to take the time to restructure their organization.
Caplinked, a trusted leader in the VDR space for M&A transactions, offers secure, interactive solutions for businesses. Its secure, integrative, and interactive VDR solution saves companies time and money in corporate transactions while making better investment decisions. DCF analyses don’t need to be complicated. For more information, begin your free trial today to see how it can help your DCF methods.
Grace Kim is a writer specializing in the nonprofit, tech, and financial services industries. Grace holds a Master of Science from NYU in Public Relations and Strategic Communications.
Street of Walls – Discounted Cash Flow Analysis
Investopedia – Discounted Cash Flow
Corporate Finance Institute – Discounted Cash Flow DCF Formula
e-Investing for Beginners- Explaining the DCF Valuation Model
Smartsheet- Pros and Cons of Discounted Cash Flow