Performing a DCF analysis involves several steps that are crucial for accurate valuation:
1. Forecast Future Cash Flows
The first step is to project the business's future cash flows, typically over a period of 5 to 10 years. This requires a deep understanding of the business model, market conditions, and growth prospects. Entrepreneurs should consider both
revenue streams and expenses to create realistic forecasts.
2. Determine the Discount Rate
The discount rate reflects the risk associated with the future cash flows and the time value of money. It is often represented by the
Weighted Average Cost of Capital (WACC) or the required rate of return. A higher discount rate indicates higher risk and reduces the present value of future cash flows.
3. Calculate the Present Value of Cash Flows
Once future cash flows and the discount rate are determined, the next step is to calculate the present value of each projected cash flow. This is done using the formula:
PV = CF / (1 + r)^n
Where PV is the present value, CF is the cash flow, r is the discount rate, and n is the year.
4. Sum the Present Values
After calculating the present value for each year, sum them up to get the total present value of future cash flows. This total represents the estimated value of the business or investment.
5. Account for Terminal Value
In many cases, the business's value extends beyond the forecast period. The
terminal value represents the value of the business at the end of the forecast period, assuming it continues to generate cash flows indefinitely. This can be calculated using the perpetuity growth model or exit multiple method and then discounted to present value.