A cash flow-based valuation model focuses on the expected future cash flows generated by a company to estimate its value. This approach is often considered more robust than earnings-based models because it directly considers the cash generated by the business, which is crucial for shareholders and investors. Here's an example of a commonly used cash flow-based valuation model called the discounted cash flow (DCF) model:
1. Projecting Cash Flows: Start by estimating the company's expected future cash flows over a specific period, typically 5-10 years. These cash flows should represent the free cash flow (FCF) generated by the company, which is the cash available to distribute to shareholders or reinvest in the business. FCF is calculated by subtracting capital expenditures (CAPEX) and changes in working capital from the company's operating cash flow. The projections can be based on historical financial data, industry trends, growth rates, and other relevant factors.
2. Determining the Terminal Value: Estimate the value of the company's cash flows beyond the projection period. This can be done by applying a terminal growth rate, which represents the sustainable growth rate of the company's cash flows in perpetuity. The terminal value captures the value of future cash flows beyond the projection period.
3. Applying Discount Rate: Determine an appropriate discount rate, often the company's weighted average cost of capital (WACC), which represents the required return expected by investors given the risk associated with the company's cash flows. The WACC considers the cost of equity and the cost of debt, weighted by their respective proportions in the company's capital structure.
4. Calculating Present Value: Discount the projected cash flows and the terminal value to their present value using the discount rate. The present value represents the estimated value of each cash flow at the present time. Sum up the present values of all projected cash flows and the terminal value to determine the total estimated value of the company.
Here's a simplified example: Let's assume a company is expected to generate the following annual free cash flows for the next five years: Year 1: $1 million, Year 2: $1.5 million, Year 3: $2 million, Year 4: $2.5 million, Year 5: $3 million. We'll assume a terminal growth rate of 3% and a discount rate of 10%.
Using the DCF model, we discount each cash flow to its present value and calculate the terminal value. Then, we sum up the present values and the terminal value to obtain the total estimated value of the company.
Year 1: Present value = $1 million / (1 + 10%)^1 = $909,090
Year 2: Present value = $1.5 million / (1 + 10%)^2 = $1,239,669
Year 3: Present value = $2 million / (1 + 10%)^3 = $1,653,439
Year 4: Present value = $2.5 million / (1 + 10%)^4 = $2,165,289
Year 5: Present value = $3 million / (1 + 10%)^5 = $2,679,609
Terminal Value = $3 million * (1 + 3%) / (10% - 3%) = $39.86 million
Total Estimated Value = Present value of cash flows + Terminal Value Total Estimated Value = $909,090 + $1,239,669 + $1,653,439 + $2,165,289 + $2,679,609 + $39.86 million = $48,506,095
Please note that this is a simplified example, and in practice, more detailed cash flow projections and additional adjustments
