Discounted cash flow valuation and indirect cash flow analyses: retracing the cash

Abstract

The discounted cash flow method determines the value of a company by the cash flows the company will be able to generate for its capital providers. Here two capital providers are relevant: Providers of equity and providers of interest bearing debt. There are three basic items that need to be addressed when performing a discounted valuation: (i) cash flow: Which cash flow and how is this calculated? (ii) Discount rate, also referred to as the WACC: Which discount rate needs to be applied and how is this determined? (iii) Continuing value: How is the continuing value calculated? Performing a DCF (free cash flow to firm) results in the Enterprise Value of a company first. In order to arrive at the price that will be paid for a company as part of an M&A transaction, one needs to determine the Equity Value. Net Debt needs to be subtracted from the Enterprise Value to arrive at the Equity Value.