# Beginner DCF Model (Simplified)

Updated: May 17, 2021

In the previous two posts, __ Free Cash Flow__ and

**Gumball-machine Valuation****we covered two important topics.**

1) Discounting and the relationship between risk and required return.

2) Free cash flow has to be discounted to a present value.

In this article, we will do a more realistic valuation but are still going to use some training wheels to make the process a little easier. What makes our example have training wheels you ask?

1) Free cash flow is given.

2) Discount rate is given.

3) Terminal growth is given.

4) No calculation of free cash flow to the firm.

5) Numerous other things we won't go into.

Despite these simplifications, it may take a second to get through.

**#1) Projecting Revenue**

We are given the following revenue information for the past 5 years

We use historical revenue data to find the historical revenue growth rates. Our inputs are in blue. Using the historical revenue growth rate we project out 5 years. In this case, we'll use the average of the 4 growth rates to project 5 years in the future. We enter our growth assumption in the cell beneath our projected revenue.

**#2) Projecting free cash flow**

Next, we see what free cash flow has been historically. In this case, it has consistently been 10% of sales. (calculated as FCF/sales)

We project that free cash flow will continue to be 10% of sales going forward. All we have to do is multiply projected revenue by 10% to find our free cash flow projection.

**#3) Discounting Cash Flows pt.1**

Next, we need to discount our projected cash flows. **Discounting each cash flow by our discount rate allows us to find the present value of cash flows**. This is done with an equation. We divide fee cash flow by the discount rate to the power of how many years in the future it is.

For example, find the present value of a 100 dollar cash flow two years from today if the discount rate is 5%.

Present Value = $90.70

In our case, we'll assume the appropriate discount rate is 7%. If we discount each cash flow by 7% for the number of years we're away from earning it we can find the present value of all our projected cash flows. (bottom right)

**#4) Discounting Cash Flows pt.2**

The cash flows we expect to receive from this business do not end after 5 years. We assume the business will continue making money for a long time. Estimating this stream of cash flows (which we assume does not end) is called the **terminal value**.

**We don't assume that a business will be able to maintain high growth rates forever** so we use what is called a terminal growth rate. A terminal growth rate is a smaller growth rate that is more achievable in the long run. Many people believe that the terminal growth rate should have an upper limit at the long-run GDP growth expectation. We will just call it 2%.

How do we find the present value of a never-ending, always-growing stream of payments? There are three steps.

1) **Grow the final projected year cash flow by the terminal growth**. (FCF t+1). Our last projected free cash flow was 227 so we will grow it by 2%. 227*1.02 = **231.54**

2) **Divide the projected free cash flow in step 1 by the discount rate less the terminal growth rate**. As an equation, it looks like this.

In our case the terminal value is

3) Finally, we **discount the terminal value back** another 5 years to bring it to the present value today. The present value of our terminal value is $3,301.

**#5) Adding it up**

In order to find the equity value of our business, we have to add the present value of our projected cash flows and the present value of our terminal value. We divide the equity value of our business by the number of shares outstanding to find the equity value per share.

We have valued one share of this business at $4.07. **How sensitive is our calculation to the discount rate and terminal growth assumptions we made?** Let's test it.

The price per share is quite sensitive to the discount rate and terminal growth rate.

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