Use discounted cash flow analysis for valuation

October 22 , 2020 |4 Comments

Use Discounted Cash Flow Analysis For Valuation

While the idea of placing a value on an emerging market firm may seem difficult, it really is not much more different than valuing a company from a more familiar developed economy; the backbone of valuation is still discounted cash flow analysis (DCF). The purpose of DCF analysis is simply to estimate the money an investor would receive from an investment, adjusted for the time value of money. Although the concept is the same, there are still a few factors specific to

emerging markets that must be dealt with. For example, the effect of exchange rates, interest rates and inflation estimates are obvious concerns when analyzing emerging market firms. Exchange rates are regarded as relatively unimportant by most analysts, since although the local currencies of emerging market countries can vary wildly in relation to the dollar (or other more established currencies), they tend to stay close in relation to the nation's purchasing power parity (PPP). So in this case, changes in exchange rate

will have little effect on the future domestic business estimates for an emerging market firm. Nonetheless, a sensitivity analysis can be performed to determine the foreign exchange impacts due to local currency fluctuations. Inflation on the other hand plays a larger role on valuation, especially for firms operating in a potentially high inflation setting. In order to neutralize the effects of inflation on the DCF estimate for an emerging market firm, it is necessary to estimate future cash flows in both

nominal (ignoring inflation) and real (adjusting for inflation) terms. By estimating future cash flows in both real and nominal terms and discounting them at appropriate rates (once again, adjusting for inflation when necessary) we should be able to derive firm values that are reasonably close if inflation has been properly accounted for. Making the appropriate adjustments to the numerator and denominator of the DCF equations removes the impact of inflation. (Calculate whether the market is paying too much for a particular

stock. Check out DCF Valuation: The Stock Market Sanity Check.)

Discounted Cash Flow Dcf Analysis

* Pro: Theoretically the most sound method if one is very confident in the projections and assumptions, because DCF values the individual cash streams (the actual source of the companyâs value) directly. * Pro: DCF method is not heavily influenced by temporary market conditions or non-economic factors. * Con: Valuation obtained is very sensitive to modeling assumptionsâparticularly growth rate, profit margin, and discount rate assumptionsâand as a result, different DCF analyses can lead to wildly different valuations. * Con: DCF requires the forecasting of future performance, which is very subjective, and most of the value of the company is usually derived from the âterminal value,â which is the set of cash flows that occurs after the detailed projection period (and is therefore usually projected in a very simple way).

Discounted Cash Flow Analysis

The Discounted Cash Flow analysis method treats the business as a large free cash flow machine. One would value the whole business for all of its worth and hold it for all of its projected free cash flows indefinitely. When we value a company’s worth, we look at its current market capitalisation compared to the company itself in order to determine whether it is profitable and worthy. An alternative method would be to divide the total estimated value by the number of shares, then compare this to the current real price of shares.

Discounted Cash Flow Analysis Dcf

If given a choice of $1000 to be received today or two years later, most people will no doubt choose to receive the money today. The reason is very simple, the $1000 received today can be put in the banks or in risk free instruments like the US Treasury Bills to earn interest. In two yearsâ time, the $1000 with interest will be worth more than the $1000 today. This simple concept forms the basis of the Time Value of Money. If given a choice of receiving $1000 today or $1050 two years later, what

would you choose? This is slightly more difficult. We will need to compare these two values on a fair and comparable basis. For example, what is $1000 worth two years later or what is the $1050 in two yearsâ time worth today? In other words, we are asking what the future value of the $1000 is in two yearsâ time or what the present value of the $1050 is now. ### Discounted Cash Flow Analysis (DCF) A DCF valuation attempts to get at the value of a company in the most direct manner possible:

a companyâs worth is equal to the current value of the cash it will generate in the future, and DCF is a framework for attempting to calculate exactly that. In this respect, DCF is the most theoretically correct of all of the valuation methods because it is the most precise. However, this level of preciseness can be tricky. What DCFs gain in precision (giving an exact estimate based on theory and computation), they often lose in accuracy (giving a true indicator of the exact value of the company). DCFs are exceedingly difficult to get

right in practice, because they involve predicting future cash flows (and the value of them, as determined by the discount rate), and all such predictions require assumptions. The farther into the future we predict, the more difficult these projections become. Any number of assumptions made in a DCF valuation can swing the value of the companyâsometimes quite significantly. Therefore, DCF valuations are typically most useful and reliable in a company with highly stable and predictable cash flows, such as an established Utility company. Because DCFs are so difficult to âget perfect,â they are typically

used to supplement Comparable Companies Analysis and Precedent Transaction Analysis (discussed next).

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Use discounted cash flow analysis for valuation