Discounted Cash Flow method (DCF)

What is discounted cash flow, and how to get started on building a DCF model. A big part of what the discounted cash flow method is all about, is right there in the name: it involves estimating future cash flows, and discounting or translating them to today’s equivalent. A lot of people use the DCF method in order to decide whether to buy, sell or hold a share of a publicly listed company. Your first steps into using discounted cash flow can be fairly easy!
⏱️TIMESTAMPS⏱️
00:00 What is discounted cash flow
00:31 Present value
01:21 Definition of discounted cash flow
01:54 DCF method limitations
02:46 DCF modeling options
04:51 Discount rate in DCF model
07:20 Free Cash Flow in DCF analysis
09:02 Number of forecasting periods in DCF
09:26 Simplest DCF possible
10:23 Enterprise value and equity value
11:31 DCF with current year free cash flow
13:20 Present value of a growing perpetuity
14:07 Draft DCF outcome comparison
15:22 Building a DCF model in Excel
17:11 Analyzing revenue data
19:59 Analyzing margin data
21:06 Analyzing operating expenses
23:18 Analyzing Operating Income
23:41 Analyzing Other Income
24:12 Analyzing interest expense
24:52 Effective tax rate
25:41 Analyzing Net Income
25:59 Non-cash adjustments
28:51 Analyzing CapEx
29:54 Reconciling free cash flow
30:09 Forecasting in the DCF model
30:54 Forecasting revenue and gross margin
32:37 Forecasting operating expenses
34:03 Forecasting Operating Income to Net Income
35:53 Forecasting Cash From Operating Activities (CFOA)
38:39 CFOA growth vs revenue growth
39:16 Forecasting CapEx spending
39:38 Free Cash Flow estimate
40:09 Applying WACC in the DCF model
42:20 Terminal Value in the DCF model
43:46 Enterprise Value in the DCF model
45:05 DCF outcome summary
46:06 Reviewing share price dynamics
47:23 Confirmation bias
47:48 Summary of practical DCF tips
If you understand the concept of present value, then it will be easy to understand discounted cash flow.
My definition of the DCF method: an attempt to estimate the value of a share today, based on projections of how much cash the company could generate in the future. You can also perform a discounted cash flow analysis on the level of the company itself, or on the level of a single investment.
In discounted cash flow modeling, you have some important choices to make: you can keep it very simple, or make it very complex. Let’s do both in this video, in a discounted cash flow #valuation case study of Verizon telecom. Come look over my shoulder as I go through various methods and calculations, and interpret the numbers.
The nice thing about keeping your #DCF modeling simple is that you don’t need a “deep” knowledge of the company, its financial statements, or finance and accounting terminology. The big risk is obviously that you might underestimate the company’s complexity and dynamics. Most people go in the direction of complexity, which might look and feel more impressive, but is dangerous if you lack “clear thinking” skills and are unable to see the big picture. If you have hundreds of line items in your discounted cash flow model, do you really understand which of those are the high impact ones? It’s easy to get lost in spreadsheet complexity, with numbers not tying out or formulas incomplete. Only go complex when you’re able to handle it!
There are basically three elements that you need to make a choice on: discount rate, number of line items in your model, and the number of forecasting periods. Each of these has a simple version, and a complex version, and options in between.
In the second half of the video, we build a DCF model in Excel! Choose a level of complexity that is manageable for you to build a discounted cash flow model.
So where do you even start, when you want to build a DCF model in Excel? First step is to load, analyze and understand historical data. This can help you understand the drivers of the business, trends, and expected ranges for certain parameters. Probably the most useful part of building a discounted cash flow model is getting a deeper understanding of the company. Once that first step is done, you next review and incorporate the company’s guidance, forecast each line item in a solid and prudent way, and “zoom out” to make sense of the Big Picture.
Philip de Vroe (The Finance Storyteller) aims to make accounting, finance and investing enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better investing decisions. Philip delivers #financetraining in various formats: KZbin videos, livestreams, classroom sessions, and webinars. Connect with me through Linked In!
Want to get access to bonus content, and/or express your gratitude by buying me a cup of tea? Join my channel as a member through / @thefinancestoryteller

[@TheFinanceStoryteller]

Enjoyed this video? Then please subscribe to the channel, and watch the sequel called "DCF Excel model" that focuses specifically on the process of building a discounted cash flow model in Excel kzbin.info/www/bejne/ipfTiYN_gbVng6c

[@beardedvillain0725]

This is incredible

[@TheFinanceStoryteller]

Thank you. 😊😊😊😊

[@zmack1830]

The financialstoryteller...... A walking legend !!

[@TheFinanceStoryteller]

😂😂😂😎😎😎 Thank you!!!

[@Adrian-cn5rk]

Definitely added this to my watch later section. I've seen other youtubers do this, but never 48min worth

[@TheFinanceStoryteller]

Hello Adrian! I hope you will enjoy the video. It's about 15 minutes on the various parameters in a DCF, as well as simple "shortcuts" on how to get some initial values. And then the remaining ~30 minutes is on building a DCF model in Excel from scratch, including the inevitable stumbling blocks you might run into. Would love to hear what you think of the full video!

[@hyxander3062]

​@@TheFinanceStorytellerthat's the way I'm doing it now, great video, thanks!

[@yixuanniu5482]

Thank you!!! I need to rewatch it again!

[@TheFinanceStoryteller]

Yeah, there's a lot of information in there. You might also try the follow-up video dealing mostly with the Excel formulas and calculations: kzbin.info/www/bejne/ipfTiYN_gbVng6c&pp=gAQBiAQB

[@sonualam6039]

Ready for boom ❤ you are doing very well

[@TheFinanceStoryteller]

Thanks for the kind words! Have you watched the sequel to this video as well? It focuses more on the calculation aspects in Excel, using the same real world case study: kzbin.info/www/bejne/ipfTiYN_gbVng6c&pp=gAQBiAQB

[@xierli8585]

This is deep, and long, need to dedicate time to appreciate it ²⁹³

[@TheFinanceStoryteller]

Yes, this certainly builds on a lot of other financial knowledge. Have a look first at some of my income statement and balance sheet tutorials in the "real world case studies" playlist to familiarize yourself with some of the terminology: kzbin.info/www/bejne/gJCUd2t9pLGCf5o&pp=gAQBiAQB My videos on free cash flow might also help, as this is the core concept of any DCF analysis: kzbin.info/www/bejne/nZ2WgH-qer1lhq8&pp=gAQBiAQB

[@edmundtan1314]

Thank you!

[@TheFinanceStoryteller]

You're welcome! Follow-up video specifically focusing on the Excel model and its formulas: kzbin.info/www/bejne/ipfTiYN_gbVng6c&pp=gAQBiAQB

[@edmundtan1314]

@@TheFinanceStoryteller thank u, will do. Love the content you made on fundamental analysis. :)

[@TheFinanceStoryteller]

Yeah, I am very interested in understanding companies. In my video "What is an ETF", I disclose my personal investment portfolio: kzbin.info/www/bejne/fXOvf36YhMyEatk

[@ds3843]

Coool!!!! Thank you!

[@TheFinanceStoryteller]

My pleasure! Happy to help.

[@lorenzoperin9211]

Thank you man, I will spend some qualitative time watching it

[@TheFinanceStoryteller]

Enjoy watching it, Lorenzo! Look forward to hearing what you think of it.

[@lorenzoperin9211]

Done - very Interesting to see all diverse methods, also always appreciate your capacity to keep it simple and sharing of lot of rules of thumb that I promote too. Btw, any M&A video to suggest?

[@TheFinanceStoryteller]

Wonderful to hear that. 😊 Here's the link to my playlist on M&A, it includes videos on M&A, goodwill, due diligence, noncontrolling interest, etc: kzbin.info/www/bejne/eHKpnpqGjdufgJo&pp=gAQBiAQB

[@VS-re5yd]

never added a video to my watch later list quicker than i did for this one.

[@TheFinanceStoryteller]

Hope you watch it soon, and enjoy it! I think it's a pretty solid one.

[@edmundtan1314]

Thanks

[@TheFinanceStoryteller]

Thank you! Appreciated. 🙏

[@MellowMelodiesGoa]

Verizon share price on 17th May 2024 is US$ 40.16 Echt heel erg bedankt.

[@TheFinanceStoryteller]

Yep, it's been going up and down pretty much between $39 and $42 in recent months. Q1 actual free cash flow was in line with what I expected, let's see how the rest of the year comes out. Big unknown is still the interest rates, which is a very significant factor for Verizon.

[@ds3843]

❤🎉

[@felipebustamante2969]

Great Video, you make a great job by explaining the Discounted Cash Flow method. There's something that bothers me though, the Idea of a terminal value that incorporates a perpetual rate of growth probably has a very low happenstance in real life. Instead of using that what do you think of multiplying the projected earnings by a factor of 10-15, like a future PE. What do you think of that?

[@TheFinanceStoryteller]

Hello Felipe, it's Philip here. 😊 Thank you for the kind words about the video. Yes, the idea of terminal value makes me uncomfortable as well (forever is a very very long time), especially when at a low WACC it amounts to such a large part of the total value. You could indeed go for a multiple approach, but it's probably better to use EBITDA than earnings in that case, in order to stay as close as possible to a cash flow driven metric. And remember that dividing by X versus multiplying by a factor of Y are complementary. Dividing by 0.05 is the same as multiplying by 20. Dividing by 0.07 is the same as multiplying by (approximately) 14.3.

[@felipebustamante2969]

@@TheFinanceStoryteller Thanks you once again for such an amazing explanation. I also discovered your twitter account and I'm following you there too. One follow up question if I may... Charlie Munger always warned us against the use of EBITDA. would it be more recomendable to use Free cash flow as the number to be multiplied?

[@TheFinanceStoryteller]

Hello again! I personally always check Gross Margin % (Gross Profit $ as % of Revenue $) and Operating Income % first when I analyze a company to get an idea of the "geography" of the profit and loss statement. I am not necessarily opposed to reviewing EBITDA (or using it in "multiple" calculations), there could actually be very good reasons to compare different companies in an industry on the EBITA or EBITDA level kzbin.info/www/bejne/pHrQoWhnr76Wr5Y&pp=gAQBiAQB Where it gets tricky is when companies use terms like "Adjusted EBITDA" (or even more exotic than that), especially if the number of line items and the $ value of the adjustments from EBITDA to Adjusted EBITDA are sizeable (and in some cases somewhat arbitrary). Have a look at my discussion of GAAP vs non-GAAP metrics: kzbin.info/www/bejne/m6jdnZqkfNmZo8k and this part of my "What is an IPO" video: kzbin.info/www/bejne/aqWZY3V7fZ50oNU Yes, I think free cash flow is a good metric to use as input for your valuation, just like EBITDA it excludes the effect of depreciation and amortization (in the free cash flow calculation, this is one of the lines that is added back when going from net income to CFOA), but its advantage is that free cash flow incorporates the effect of changes in working capital (which EBITDA does not) as well as capital expenditures (which EBITDA does not). However, be careful, as free cash flow is a non-GAAP metric and some companies take poetic liberties in coming up with their own special definition: kzbin.info/www/bejne/nZ2WgH-qer1lhq8 As Buffett says/does: read that annual report in detail, before you put your money into it!!!! ;-) Feel free to send me a connection request on Linked In as well, I am pretty active there. Tried to find you, but there are several people with the same name as you....

[@felipebustamante2969]

@@TheFinanceStoryteller Thank you Phillip! Much clearer now. Your channel is a gem! I sent you a linkedin request.

[@TheFinanceStoryteller]

Hello Felipe! The Linked In request did not come through, can you check? My full name is Philip de Vroe.

[@kennethyujin841]

the Share price of Verizon today is 40.94%

[@TheFinanceStoryteller]

Yep, it has pretty much been moving "sideways" for the past couple of months. I am still holding on to my shares, as I am optimistic of Verizon's future.

[@Laugh4laugh52]

Please how did you calculate for the terminal value growth rate?

[@TheFinanceStoryteller]

I didn't really calculate it, but have instead estimated it. In my estimates for the DCF Excel model, I put revenue growth at 3% to start with (for 2024 through 2026), and then slowing to 2% growth per year (2027 and 2028). I expect CFOA and Free Cash Flow to grow at similar rates. 2% growth also seems to be reasonably in line with the long term expected growth of the US economy, which is the primary market that Verizon operates in.

[@Laugh4laugh52]

Please, can you let me know how the Operating Income Amounted to such values?

[@TheFinanceStoryteller]

Telecom in the US seems to be a business with good margins. For Verizon, with Gross Margin of 59% of revenue, minus SG&A at 22-23% of revenue, minus depreciation and amortization, minus goodwill impairment (2023 only), that equates to Operating Margin at 22-23% of revenue.