An article to better understand the DCF method of valuing a company in 3 minutes!
There are several methods of valuing a company. Here are some examples:
- The earnings method: This method consists of estimating the value of the business based on its expected future earnings. A profit capitalization rate can be used to determine the value of the business.
- The book value method: This method uses the book value of the company's assets, as reported in the financial statements, to estimate its value. This method may underestimate the true value of the business if its assets are undervalued or overestimate the value of the business if its assets are overvalued.
- The market value method: This method consists of estimating the value of the business based on its market value, i.e. by comparing the business to other similar businesses that have recently been sold.
- The asset value method: This method consists of estimating the value of the company by adding the value of its assets and subtracting its debt. This method may underestimate the value of the company if it has intangible assets such as patents or trademarks that are not accounted for in the asset value.
There is no single valuation method that is appropriate for all companies. The choice of valuation method depends on many factors, such as the nature of the business, its financial characteristics and the information available. In general, a combination of valuation methods is recommended to obtain the most accurate estimate of the company's value.
Focus on the DCF method for valuing a company
The net present value method (DCF for discounted cash flow) is a method of valuing a company that consists of estimating the value of the company based on its expected future cash flows. The net present value is obtained by discounting these future cash flows at a discount rate that reflects the company's cost of capital and the risk associated with these cash flows.
To use the DCF method, one must first establish a medium-term financial forecast for the company. These forecasts typically include sales, costs, earnings before interest and taxes (EBIT), interest and taxes. Next, estimate the value of cash and cash equivalents that will remain at the end of each forecast period. Finally, discount these future cash flows at a discount rate to obtain the net present value of the business.
The DCF method is considered a reliable method of valuing a company, because it takes into account the company's expected future performance. However, it requires precise financial forecasts and assumptions on the actuarial rate, which can significantly affect the final value of the company. It is therefore important to understand these assumptions and to adjust them accordingly.
The calculation of the WACC in the DCF method
The wacc (weighted average cost of capital) is the discount rate used in the net present value method (DCF) to discount expected future cash flows to their present value. It reflects the average cost of capital of the company and the risk associated with these cash flows.
The wacc is calculated by weighting the company's cost of capital (cost of equity and cost of debt) by their respective weight in the company's capital. Here is the general formula for calculating the wacc :
- wacc = (Equity weighting * Cost of equity) + (Debt weighting * Cost of debt)
The weighting of equity and debt are calculated as follows:
- Equity Weighting = Equity Value / (Equity Value + Debt Value)
- Debt weighting = Debt value / (Equity value + Debt value)
The cost of equity capital is generally estimated using a rate of return required by shareholders (rp). The cost of debt is generally estimated using the effective interest rate on debt (rd).
It is important to note that the WACC is an assumption that can significantly affect the value of the company estimated by the DCF method. It is therefore important to understand the assumptions used to calculate it and to adjust them accordingly.