Discounted cashflow (‘DCF’) is a method under income approach to estimate today’s worth of an asset, shares, business, or a project using projected cashflows. The method considers fundamental drivers of the business to value the asset (e.g., cost of equity, growth rate, etc.) than public market factors, and allows expected operating strategies to be factored in valuation along with sensitivity analysis.

Under DCF method, present value of future cashflows is arrived by discounting free cashflows for the forecasted period (normally 5 to 7 years) and terminal value of business beyond a forecasted period using an appropriate discount rate. 

Key components of DCF:

• Discount rate: Discount rate is the weighted average of cost of capital for the funds taken from equity and debt providers.

• Cost of equity is generally calculated using capital asset pricing model (‘CAPM’) or Gordon growth model (‘GGM’). Under CAPM, the valuer has to apply his best judgement in determining risk premium and beta of the corresponding sector whereas in case of GGM since it considers stable dividend growth rate every year, it is difficult to apply on private companies. 
• Cost of debt is the interest paid by the company after tax.

• Risk-free rate: The country’s long-term government bond yield is believed to be the most secure and credible source of return. Thus, it is considered as risk free rate in the cost of equity formula of CAPM.
• Equity risk premium: This is one of the components of CAPM. Equity investors are compensated by excess return over the risk-free rate for taking risk. 
• Beta coefficients: Beta is the measure of sensitivity of a company’s volatility in relation to the changes in the overall market.
• Terminal value: It is the value of the Company beyond a forecasted period under the going concern assumption using perpetual growth method or exit value method.

Certain risk premiums are applied on discount rate to make it more specific towards the subject asset being valued such as:

• Illiquidity premium is provided when the asset is not readily convertible into cash
• Small company premium is the most widely used add-on to the cost of equity in practice and is provided when acquiring smaller divisions or smaller companies
• Asset-specific risk premium depends on the asset that is being valued as deemed fit by the valuer
• COVID α premium is provided due to the effects of changes in market on the asset or company because of COVID-19
• Country-specific premium

As shown in a diagram below, we can find out the enterprise value and equity value using DCF method under FCFF* and FCFE# approach

*FCFF: Free cashflows to firm l #FCFE: Free cashflow to equity

The main limitation of DCF is that it requires considering many assumptions to estimate the future cashflows when future cashflows are mainly dependent on the market demand, economy status and unforeseen obstacles. Following are the challenges while applying DCF method: 

DCF model is generally used when a company gets an infusion of capital. Investors can use this method to determine whether an investment generates positive cashflows with suitable valuation. Being registered valuers and having performed numerous valuations, Acumen M&A Advisors assists organisations in arriving at appropriate projected cashflows, determining the present value of their businesses and thus, making overall well-informed business decisions.