Is Discount Cash Flow Method a Good Way to Evaluate a Company?

Abstract

This research paper focuses on the previous study on the discount cash method to value the company and gives basic understanding of the discount cash flow method. When we use DCF method, there are many assumptions and critical things need to be considered. For instance, the discounted rate and future cash flow. This research paper provides ways to forecast these numbers and briefly summary the advantages and disadvantages of the DCF method.

Key words: discount rate, future cash flow, discount of future cash flow

Introduction

Why people care about value a firm? Which stock should we buy? Why people are always figuring out ways to correctly determine the structure of the company? The reason is as simple as people want to know whether it is safe or not to invest money in one specific company or a firm in S&P 500 index. Making money is the strongest incentive to do the valuation. At this point, giving an accurate estimation of the stock price or the value of the firm becomes very important. Discount cash flow method plays an important role in giving the answer to this issue. By forecasting the future cash flow which can be 10 years or permanent and the appropriate of discount rate of return which is often affected by economic environment and the strategies of the company’s investment, DCF method is one of the approach to the value of the firm. This research paper provides ways to forecast these numbers and briefly summary the advantages and disadvantages of the DCF method.

Most cash flow is always generated from the operating activity which is a company’s core business. According to Richard S. Ruback (2010), “the cash flow forecasts are the expected cash flow that occurs in the future based on the historical performance and the blueprint of the corporate. Expected cash flow is correlated with the opportunities for the product, the firm, its divisions or its industry” (p.5). The forecast cash flow should consider all the opportunities for the company to get an accurate result. In practical, it is very difficult to avoid the biased about the measure of the expected cash flows, especially for some high-technology companies. As the speed of replacement of the product is so quickly, the future cash flow for the high-technology firms is not stable and hard to preciously lock the price. As a result, the predicting of future cash flow can change under different scenarios and should be based on different company. Richard S. Ruback (2010) mentioned that to be a measure of the expected cash flows, the forecasts ought to consider the full range of potential outcomes and then weigh the resulting cash flows in each outcome by their respective probabilities.(p 10).

A proper discount rate of return often serves as a preference of keeping money today instead of consuming it. Future cash flow is discounted or divided by the rate of return is the presentation value of the firm. From the definition, a little change in the discount rate of return can result in a big change in the present value of firm. Many factors affect the discount rate of return, such as economic environment, the leverage of the debt which is total debt divide the total equity of the company, the risk free rate of the whole society, the tax rate of the firm and many other factors. It is more variable than the future cash flow as discount rate of return is more sensitive to the economic change and the performance of the company. At the same time, it is more hard to be estimated. To solve this problem, weight average cost of capital comes into picture.

Forecast the future cash flow?

Typically, there are two ways to calculate the future cash flow: the free cash flow to the firm(FCFF) and the free cash flow to equity(FCFE). FCFF method is that the cash flow goes into the firm and this amount is available to both debt holders, often refers to bond holders, and the share holders who have the stocks of the company. Pablo,Fernandez, (2010) noted that FCFE method is just the cash flow goes into the share holders only (p 12). What’s more, MagedAli, RamziEl-Haddadeh, TillalEldabi Ebrahim Mansour (2010) added that “FCFF is a measure that consists of expenses, taxes and changes in net working capital and investments while FCFE method does not include the tax because it is just the cash flow to the share holders only.”(p21) When people invest in a firm or do acquisition, they want to have the control rights of the company, FCFF method in this case is more widely used in practice. What’s more, Florian Steiger,(2008) said that under FCFF method, the interest payments have already been deducted. The formula for FCFF method is :