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By Julia Lundstrom, CFP® | The Traders Wire

In the middle of a recession and rising inflation, no one can ever be certain of what the future holds. As an investor, the best thing you can do is build a Discounted Cash Flow model to predict the future value of an investment based on expected cash flows.

What is A DCF?

A Discounted Cash Flow model is a valuation method that estimates the value of an investment using expected future cash flows.

The DCF analysis attempts to determine the present value of an investment, based on projections of how much money the investment will generate in the future.

Here’s the formula from Investopedia:

Discounted Cash Flow Formula

DCF = CF1/(1+r)¹ + CF2/(1+r)² + CFn/(1+r)ⁿ

Where:

  • CF1 = Cash Flow for Year One
  • CF2 = Cash Flow for Year Two
  • CFn = Cash Flow for additional years
  • r = The Discount Rate

That said, it becomes doubly hard to estimate the value of an investment based on expected future cash flows. While a DCF may be the solution to all your woes, take what you learn with a grain of salt. 

How Can You Build A DCF Model

Building a DCF Model is difficult but can be done

Project Unlevered FCFs – Project the financial statements and take into account the stage the company is in. From here, you can calculate the firm’s free cash flow – which the following formula can do: 

Free Cash Flow to Firm or FCFF Calculation = EBIT x (1-tax rate) + Non Cash Charges + Changes in Working capital – Capital Expenditure

Choose A Discount Rate – To calculate the discount rate, you can use the weighted average cost of capital. The WACC can be calculated by multiplying the cost of each capital source by its relevant weight by market value 

Calculate The TV- The Terminal Value can be calculated by taking the final year projected cash flow * (1+Infinite Growth Rate)/(Discount Rate-Long Term Cash Flow Growth Rate)

Calculate The Present Value – Working our way backward, we can calculate for the present value of our terminal value by taking cash flow and dividing it by (1+i)^t where i = discount rate and t= time periods. From there, you subtract your initial investment to get your net present value. 

Make Adjustments – Once you’ve calculated the present value, you can now make adjustments to the non-core assets and liabilities that have not been accounted for in the free cash flow projections.

Julia Lundstrom

About the author

Julia Lundstrom has been a Certified Financial Planner® since 2003, managing over $60 million of assets before selling her practice in 2009. Before that, she was an investment manager for a Silicon Valley venture fund. After 3 market crashes in her career, she is her to help guide you in the markets for The Traders Wire.

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