How do I Perform a Discounted Cash Flow Analysis?
Discounted cash flow (DCF) analysis is a valuation method used to estimate the present value of an investment based on its future earnings. This process involves the following steps:
- Project Free Cash Flows (FCF): Estimate the cash the business will generate for a specific period, such as five years. For example, a restaurant might project annual FCF starting at $50,000 and growing at a set rate.
- Select a Discount Rate: Choose a rate that reflects the risk and opportunity cost of capital. Industry benchmarks like the weighted average cost of capital (WACC) typically range from 8% to 12% for retail, with higher rates for riskier startups.
- Calculate Present Value: Use the formula V0 = sum of [FCF / (1 + r)^t] to discount each year’s projected cash flow back to its value today.
- Determine Terminal Value: Estimate the business value beyond the forecast period using a growth model, then discount this value back to the present.
- Calculate Net Present Value (NPV): Sum the discounted cash flows and the discounted terminal value. If the total NPV is higher than the investment cost, it indicates a worthwhile investment.
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