DCF financial model explained and why you need it

Ante Kristo

When you think of asset valuation, the first thing you question yourself is what is the most efficient way of evaluating a business or asset? The first thing you think of is DCF financial method. The question we want to answer in this article is, what are the steps to successful assets or business evaluation? How well you are familiar with the DCF financial model and asset valuation? These are just some of the questions, we will help you answer in this article.

According to Corporate Finance Institute, a DCF analysis is performed through a financial model in Excel and requires an extensive amount of detail and analysis. It is the most detailed of the three approaches, requires the most assumptions, and often produces the highest value.

For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modelled individually and added together. In addition, the advantage of the DCF financial model over other valuation methods is valorisation of the companies without positive cash flow. Therefore, negative cash flow when using EBITDA is commonly used in making assumptions.

In the DCF financial model, a way around having to guess a company’s long term growth rate is to guess the EBITDA multiple. Therefore, you can value the company in the last year of stage one forecast.

A common way to do this is to look at the current EBITDA multiple the company is trading at the present stage. That way, you can assume the company will be at value with the same multiple in the future. For example, if Slack is 8.0x. its last twelve months EBITDA assume that in 2022 it will value at 8.0x. its EBIDTA.

Key Assumptions in the DCF financial model

The key assumptions in the DCF financial model include the operating assumptions, the weighted average cost of capital (WACC), Terminal value assumptions. The cost of equity is essentially the amount that a company must spend to maintain a share price that will keep its investors satisfied and invested. The debt-linked component in the WACC formula represents the cost of capital for company-issued dept.

Moving forward, the operating assumptions are forecasting revenue growth and operating margins. With the correct data, some companies report product or segment level revenue and operating detail in footnote. Therefore it is highly important that the final analysis includes detailed historical breakdown.

You should keep in mind, that not all companies will classify their operating results. Some companies will put all operating expenses in one row, while others will break them apart. If you want your model to compare with other companies, the classifications need to be aligned. This requires a more detailed breakdown in footnotes.

Since the majority of companies prepare their data using IFRS. Not all data will contain financial metrics like EBITDA that ignore some of the crucial factors. As a financial professional, you will often have to dig dipper and extract data that will be beneficial. This includes some data scrubbing, especially if you want to get to the core data. Nevertheless, as a financial professional, an essential part of the business is to present data in a meaningful way to the client.

Other valuation methods

There are few methods used by practitioners to value a business or asset: DCF analysis, comparable company analysis and precedent transactions. Most financial companies use these methods in mergers and acquisitions M&A, private equity and venture capital or leveraged buyouts (LBO) to evaluate a business or asset.

There are more financial valuation methods you can use in evaluating business or asset.
There isn’t a one size fits all company evaluation if you want to create a thorough analysis of the company or an asset. Among all company valuations methods, there is no ideal solution. It all comes down to, the positive and
negative effects of the method and how to decide which one is best for your business. In the following text, we will explain to you each valuation method and help you decide which one is best for your business.

Comparable company analysis

Commonly accepted method in company valuation model is Comparable company analysis. In this method, you can easily compare the current business value to another similar business. This method is performing with the help of trading multiples such as EBITDA. The term, EBITDA is a measure of the company operating performance. Using this measure you do not have to factor the company’s accounting or tax decisions.

You can use this valuation model as one of the financial methods in asset valuation. This method is easy to use and is broadly accepted in making fast calculations. A comparable company analysis (CCA) is a process to evaluate the value of a company using the metrics of other businesses of similar size in the same industry.

CCA is unlike DCF a relative form of valuation based on a similar metric comparison of the two companies. With this method, investors are able to compare a particular company to its competitors on a relative basis.

Precedent Transaction analysis

In this method, you can evaluate the company or asset in comparison to other businesses that are sold or acquired within the same industry. You can use Precedent Transaction analysis when you want to evaluate M&A transactions.

However, this method can easily become outdated as the market trends change over the years. For example, the previous market part could be at a different stage in the business cycle. Since the precedents quickly become old, this is a less used method for company valuation than comparables company analysis.

Although the biggest advantage of this valuation method is publicly available metrics, the information related to the company can be limited. Other advantages of this method include M&A discussion and negotiations to have a precedent transactions overview can be useful. The method can reveal to the buyers and sellers valuable information such as industry consolidation trends.

On every given transaction you should do your research. Whenever possible, try to use the primary source of company data. Always keep your data points consistent.

Pitfalls to avoid when using assets valuation

There are several ways mistakes can occur when creating assets valuation. Before you start your assets or company valuation, be sure to consider the following tips. If you are looking to avoid common pitfalls in valuation and analysis of data, follow these rules for each method.

1. The DCF company growth rate tip

One of the pitfalls you want to avoid is the cost of capital miscalculations. The most common doubt with cash flow projection is the wrong assumption. The projection years of the model can be total shots in the dark. Therefore, we suggest you five or ten years’ worth of estimates for each year in the forecast and DCF model.

The company growth rate assumptions in the DCF model are the growth rate and discounted rate. Professional use growth rate as a perpetual growth rate assumption. However, it is highly theoretical to think everything will stay in perpetuity. Therefore, we recommend you to conduct assumptions on the long term rate of economic growth. Besides, company growth can change over the years.

2.Company size and EBITDA value

Projected earnings and EBITDA are subject to all kinds of pitfalls. You will have to adjust performance for charges, expenses such as sale of assets. Making accurate calculations to make assumption is imperative to assets valuation. Always validate your key fundamental metrics, select appropriate multiple and confirm relevant peer universe.

3. Do not take the raw data from a Financial Database

Similar to the DCF model, all other assumptions such as precedent and comparable company analysis have the same rule. The most important tip is to be careful when you take data from a Financial Database. In addition, keep in mind that not all the data will fall into apples to apple comparison of the companies.

There are different metric you have to consider in asset or company assumptions. Geography is one of the metrics you should consider in terms of comparing companies in the same region. Plus, we recommend considering the company size in comparison.

To summarize, it doesn’t matter if you plan to sell your business or not. It is always good to have a complete valuation of your business done.

This is essential if you are looking for investors to fund your business. In a company or asset valuation, we recommend using more than one method. Therefore, we have listed in this article many ups and downs when using each valuation method. We hope you now have a better understanding of asset valuation methods, especially the DCF financial model.