Discounted Cash Flow model indicates the fair market value of a business based on the value of cash flows that the business is expected to generate in future. This method involves the estimation of post-tax cash flows for the projected period, after taking into account the business’s requirement of reinvestment in terms of capital expenditure and incremental working capital. These cash flows are then discounted at a cost of capital that reflects the risks of the business and the capital structure of the entity.
Discounted Cash Flow is the most commonly used valuation technique, and is widely accepted because of its intrinsic merits which are given below:
(a) Theoretically, it is a very sound model because it is based upon expected future cash flows of a company that will determine an investor’s actual return.
(b) It is based on expectations of performance specific to the business, and is not influenced by short-term market conditions or non-economic indicators.
(c) It is not as vulnerable to accounting conventions like depreciation, inventory valuation in comparison with the other techniques/approaches since it is based on cash flows rather than accounting profits.
(d) It is appropriate for valuing green-field or start-up Income Approach Share Valuation projects, as these projects have little or no asset base or earnings which render the net asset or multiple approaches inappropriate. However, it is important that valuation must recognise the additional risks in such a case (e.g. project execution risk, lack of past track record, etc.) by using an appropriate discount rate.
In this technique valuation of shares is based on three things: Cash Flow Projections, Discount Rate and Terminal Value.