Discounted Free Cash Flow Basics for Investment Banking
The basic discounted free cash flow model requires the analyst and investment banker to complete two basic tasks: First, the analyst must estimate future cash flows to the firm. After creating the cash flow estimate, the analyst must forecast the appropriate discount rate (an interest rate that is used to put a future cash sum into today's dollars) to apply to those cash flows.
The value of any financial asset can be determined by the following basic formula:
where CFn is cash flow at time n and r is the appropriate discount rate.
Don't let the scary appearance of the formula rattle you. It's just the mathematical way to state that the value of any asset is simply the present value of all future cash flows that the owner of that asset is entitled to. So, the value of a bond is simply the present value of all the interest payments and the return of principal value that the bondholder receives.
Likewise, the value of a share of stock is equal to the present value of all the future dividend payments that the stockholder receives.
The value of an entire corporation is determined via a model that estimates free cash flows to the firm and discounts them back to the present via a discount rate called the weighted average cost of capital.
Free cash flow (FCF) is not a formal accounting concept like gross margin or net income, so it's sometimes defined somewhat differently by different people. In its most basic form, free cash flow is the amount of cash flow from operations (CFO) remaining after paying for any needed capital expenditures.
CFO is simply the cash flow generated by normal business operations and doesn't include items that may be one time in nature — such as the sale of a building or even the sale of an entire division. Capital expenditures are investments that a company must make to replace assets that are worn out and need replacing or expenditures made in new assets to fuel future growth.
In addition, since FCF is cash flow available to all capital suppliers (including bondholders), interest expense needs to be added back (net of taxes) in computing FCF. The net of taxes aspect refers to the fact that interest on debt payments are tax deductible. So, FCF is computed as follows:
FCF = CFO + Interest Expense (1 − Tax Rate) − Capital Expenditures
The discounted free cash flow model states that the value of the firm is equal to the value of all future free cash flows to the firm discounted at the WACC:
One thing that may trouble you when looking at the formula is that it has an infinite number of terms. Don't despair. As you'll see, by making a simple assumption or two, the formula breaks down into a finite and very manageable number of terms.