Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

ESTIMATION OF CASH FLOWS

The first step in the DCF process is the estimation of the individual cash flows. The definition of the cash-flow stream is critical to this type of analysis. Most people use free cash flow or net cash flow. These terms, which are used interchangeably, are normally defined as follows:

projected adjusted income after income taxes;

plus reported depreciation and amortization;

less necessary capital expenditures;

less necessary working capital increases; and

less debt principal repayments, sometimes also

adjusted for the issuance of new debt.

Stated in simplified form, free cash flow is the sum of the sources of cash, less the capital expenditures necessary to stay in business and continue to grow at the expected rate. These expenses must be included because a company cannot remain in business if its capital machinery gets old and outdated, nor can it grow without increases in working capital. The goal is to estimate recurring operating earnings and all cash-flow items associated with those earnings, including necessary capital expenditures. These estimates are the first area of subjectivity in the DCF valuation approach.

One way to estimate the annual cash flows is to use the company’s financial history as the base for projections. There are many ways to use historical data. One of the best is to build a financial model of the company. The model may be very simple, for example a mathematical relation between sales and employees (either in dollar terms ...