# The Practical Application of Discounted Cash-Flow Based Valuation Methods

**Topics:**Balance sheet, Asset, Generally Accepted Accounting Principles

**Pages:**20 (5795 words)

**Published:**March 10, 2013

THE PRACTICAL APPLICATION OF DISCOUNTED CASH-FLOW BASED VALUATION METHODS Publication: Studia Universitatis Babes Bolyai – Oeconomica, LII, 2/2007 Author Name: Takács, András; Language: English Subject: Economy Issue: 2/2007 Page Range: 13-28 Summary: Valuation methods based on Discounted Cash-Flow (DCF) play a major role in the field of company valuation. The current literature contains a reasonably deep and detailed theoretical basis for DCFbased valuation, although, when starting to apply the techniques to evaluate a real company, some practical problems may appear. This study summarizes the most important practical difficulties which may hinder the valuation process and proposes different ways of solving these. Beyond the theoretical discussion, the author illustrates the techniques with a case-study, using the financial figures of a fictive firm. Keywords: company valuation; discounted cash-flow methods;

The Practical Application of Discounted Cash-flow-Based Valuation Methods

András TAKÁCS Faculty of Business and Economics, University of Pécs, Hungary

Abstract. Valuation methods based on Discounted Cash-Flow (DCF) play a major role in the field of company valuation. The current literature contains a reasonably deep and detailed theoretical basis for DCF-based valuation, although, when starting to apply the techniques to evaluate a real company, some practical problems may appear. This study summarizes the most important practical difficulties which may hinder the valuation process and proposes different ways of solving these. Beyond the theoretical discussion, the author illustrates the techniques with a case-study, using the financial figures of a fictive firm. Keywords: company valuation, discounted cash-flow methods

1. The general DCF model The discounted cash-flow models interpret a firm’s value as the present value of cash-flow generated by the firm in a specified future period. Future cash-flow should be discounted at an appropriate discount rate, but these methods require a very careful forecast of the flows for each future period. The calculation formula depends on whether the company has been established for a specific term only (project companies) or for an indefinite period of time. a) Valuation of project companies A project company is established for a specified task and for a definite time period. After closing its operations, liabilities are settled and the remaining assets are sold, creating an additional cash inflow for the shareholders. Therefore, the valuation is based on the following formula:

V0 =

where

n CF1 CF2 CF + RVn CFi RVn + + ... + n =∑ + n i 2 1 + r (1 + r ) (1 + r ) (1 + r )n 1 i =1 ( + r )

(1)

V0: value of the firm in period 0 CFi (i=1,2,…,n): estimated cash-flow for period i r: appropriate discount rate matched with the cash-flows’ risk RVn: residual value of the firm at the end of period n (net cash inflow from selling the assets) 13

b) Valuation based on the going concern In the normal case, a company is established to operate in an indefinite future. According to the going concern, we should always assume that the firm will continue its operations in the future. Therefore, the previous formula should be modified as follows:

V0 =

∞ CF1 CF2 CFi CFi + + ... + + ... = ∑ 2 i i 1 + r (1 + r ) (1 + r ) 1 i =1 ( + r )

(2)

In order to correctly apply the above formulae we have to make it clear how we calculate the ‘cash-flow’ for each period what is the ‘discount rate’ used to compute the present value of the flows. The relevant literature has elaborated many different discounted cash-flow 1 techniques , the most generally applied of which is the so-called Free cash-flow model. Free cash-flow (FCF) is the cash-flow generated by the firm in the current period, without taking into account the effect of debt financing. It is the money which would be available within the firm assuming that there is no debt and, therefore, that there are no...

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