Discounted cash flow valuation is a technique used to determine the current value of a company by use of future cash flows which have been adjusted for time value. The future cash flow set can be said to be the cash flows which have been determined over a given forecast period and a continuing value which is a representation of the cash flow stream after this forecast period. This article gives important tips on how you can achieve improved results from this valuation.
Forecasting Cash Production
To forecast cash production accurately, you need to focus on the all the available information regardless of the type of investment you are valuing. Cash flow valuation usually depends on discounting a variety of numerical values, with the nearest values to inherently garner more weight.
It is much easier to forecast the cash flows of a business during a healthy economic cycle because it is more predictable. In the same way, prediction of cash production is relatively straightforward for larger and more diversified companies or any business in an industry which is normally stable.
So, how do you perform the valuation when dealing with a growth company or a certain new project without any history? For these types of investment, the best method is to make comparisons of the average cash flow growth rates with those of similar expanding business entities in the same segments. A good example is comparing a high-growth telecommunications equipment business with a similar one which passes through the same growth process in the past.
Decide on a Terminal Value
A normal discounted cash flow valuation takes a forecasting period of about 10 to 15 years. Beyond this period, it virtually impossible to make any accurate forecast cash flows. Preparing a big spreadsheet for making forecasts for the next 30 years is not useful in any way unless you are dealing with long-dated investments such as utility plants and mortgages.
To make a viable valuation, you need to utilize two main techniques. The first method is by projecting that you will sell your investment at the end of the determined forecast period for amount referred to as terminal value. The second method is by calculating a perpetuity or annuity value of all future cash flows beyond your last forecast period. It can be just a fixed or growth annuity and the method is popular for predictable investments such as health insurance, pipeline projects and large cap dividend-paying stocks.
Customizing Your Discount Factors
Another great component of discounted flow valuation beyond your cash forecasts is customizing your discount factor. By use CAPM, it is possible to estimate the value of your discount factor just by changing the beta factor. These market-derived betas can be taken from one of the major data providers which include Reuters or Morningstar for most of the industry segments or public company sizes.
When you not dealing with a publicly traded stock or when your investment does not have an equivalent in the markets, the beta value become meaningless. In this method you can turn into buildup method which begins with equity risk premium and risk-free rates all derived from a relatively close market proxy.
A discounted cash flow valuation is a very effective technique and will work well to give optimum results if you follow these important tips efficiently.