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Chapter 2 modelling innovation - teaser

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This chapter focuses on DCF valuation, including the following topics:

What is the Discounted Cash Flow method?
When should it be used?
What are the advantages and disadvantages of the DCF method?
How is a DCF valuation structured?
We tried to cover not only the why i.e. what are the advantages of the Discounted Cash Flow methodology but also the how i.e. in practice, what steps are required to build a credible DCF valuation.

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Chapter 2 modelling innovation - teaser

  1. 1. Chapter 2 - The discounted cash flow method1 2.1 What is the DCF Method? The Discounted Cash Flow (DCF) Method is a theoretical estimation of the present value of a project, business or company’s assets. The methodcalculates the intrinsic value of projected cash flows adjusted for the time value of money and the cash-flow risk (risk premium). The output is the present valueof the stream of cash flows. The value that results from the DCF calculations depends on the cash flows being discounted. Free Cash Flow to the Firm (FCFF) is defined as the cashflow generated by a project or a company’s operations before any debt service or interest paymentsare taken into account. If the cash flows taken into account forDCF purposes are the FCFF, the resulting value is equal to the enterprise value (EV). If Free Cash Flows to the Equity (FCFE, defined as residual cash flows toequity holders after deducting the amounts needed to service the debt and pay interest) are taken into account, the resulting valuation corresponds to a measure ofthe equity value, which can be compared to the market value for quoted companies. The DCF method rests on certain assumptions for projections of company revenues, costs and projected investments as well as financial assumptions,including the Weighted Average Cost of Capital (WACC). While the method is extremely sensitive to these assumptions, practitioners agree that it remains aleading method of company valuation. The right approach consists of acknowledging the method’s limitations, including its sensitivity to certain assumptions (namely, the weighted averagecost of capital), and ensuring that these assumptions mirror reality as close as possible. For new projects with limited history, analyst experience is of greatimportance. In contrast, for existing companies with a track record, use of historical figures that correspond to the company’s actual track record across thebusiness cycle constitutes best practice. Honest assumptions and historical figures guarantee valuation integrity. The fact that a small change in the assumptions 1 © 2012, Hugo Mendes Domingos and Eduardo Vera-Cruz Pinto 1
  2. 2. leads to a significant change in valuation only causes concern when those responsible for the valuation cannot back up their assumptions or build credibility intothe numbers. The difficulty in the assumptions of DCF is not related to the method itself but rather to the actual assumptions being used. Those using the DCF method for investment analysis, decision-making or as a backup tool for negotiation should focus on carefully supportingtheirwork and understanding the valuation’s sensitivity to key assumptions. Once these critical aspects are covered, the analyst will find that the valuation discussionis enhanced within the team and with third parties. Equation 1below illustrates the formula used for calculations with the DCF method. Equation 1. DCF Formula 2.2 When should the DCF Method be used?The teaser is over! If you want to read the rest, you will have to wait until the full print is available at http://www.innovation-models.com 2

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