Discounted Cash Flow

Discounted Cash Flow (DCF) is by far the most accurate and reliable tool used to evaluate whether a merger or acquisition with be a profitable one. The discounted cash flow analysis allows deal makers to predict future cash flows of a company which in turn allows them to determine a company’s present value. Forecasted free cash flows are predicted by adding operating profit, depreciation, and amortization of goodwill and subtracting capital expenditures, cash taxes, and change in working capital. These forecasted free cash flows are discounted to a representative present value based on the company’s weighted average costs of capital (WACC). This formula is complicated and can be confusing to some but is the most reliable predictor available. In order to explain the DCF further, the following sections will explain the some of the more complex parts that make up the DCF formula.

Operating Profit

This type of profit is sometimes called recurring profit as it refers to the profit that comes from a business’ own operations and only that business’ operations. These profits do not include any profits that come from investments made by the business.

Depreciation

Depreciation is defined as an expense that reduces the value of a long term tangible asset. The expense is a non-cash expense and increases free cash flow while decreasing reported earnings. For example, if a company bought a piece of machinery that cost $10,000 and the machinery was expected to be useful for 10 years then the machinery would be depreciated over that 10 year span. Every year for those 10 years, the company would figure in $1,000 dollars of expense because of initial price of the piece of equipment. In reality, $1,000 in cash would not be spent every year. This results in more cash flow, while the earnings reported are decreased.

Weighted Average Costs of Capital (WACC)

The WACC is equal to the percentage of financing that is equity, multiplied by the cost of equity. This number is then added to the percentage of financing that is debt, multiplied by the cost of debt. This figure is then multiplied by the number that is obtained from the equation, 1- the corporate tax rate. This is how the WACC is determined.