Dear Friends, Hope the last post helps you in understanding the basic fundamentals and assumptions that we take while doing valuations. But now the question is how should one approach while using DCF to do valuation. What should he look upon before doing valuation? What should be his assumptions? And many more such intriguing questions.
But before getting into the complex but simple (Complex for those who mug up valuations and simple for those who understand valuations) world of DCF, Let’s first understand one important property of DCF that greater the value of the cash flow that a firm will generate in the beginning greater will be the value of the firm, than the firm whose cash flow in the beginning is smaller compare to later years. The concept is simple because with increase in time the present value of the cash flow decreases, which means that getting Rs. 100 one year from now will have more value than getting Rs. 100 two year from now. Second important thing that we must put into mind while doing valuation is that it not only considers the present cash generation capacity of the firm but future cash generation also. Hence, one must have thorough knowledge about the company and the industry to which it belongs while doing the valuations so that he can take right assumptions about the company.
There are two types of methods that come under DCF; those are FCFF and FCFE, where FCFF stands for Free Cash Flow for the Total Firm whereas FCFE stands for Free Cash Flow to Equity. If your assumptions and calculations about the company are right then you can easily get the value of one from the other though there are separate formulas available for calculating the value of each method, which I will explain in later post.
FCFF= FCFE + Total Debt
Now, while using the above formula you must be cautious that what should be the value of total debt. Should it include both long term and short term or just the long term debt? For this one will have to keep certain things in mind. Firstly, it is on you that what debt amount you are going to use for calculating one value from the other ( FCFF from FCFE or vice versa), but whatever value of the debt you are going to use you must use the same thing while calculating the cost of capital(WACC- will explain its concept in later post) also.
Now, the question is when to use FCFF and when to use FCFE? In order to answer this question you must keep in mind that for which purpose you are going to do the valuations. If you are doing it to find the value of the total firm then goes for FCFF or if you want to do the valuation for equity goes for FCFE. Secondly, you can use FCFF to find the value of FCFE for the firm which is having stable leverage ratio (Debt/Equity ratio) over a period of time. It means that the firm which is having stable leverage ratio over a period of time, you can first calculate FCFF and then subtract the value of Debt to get the value of FCFE rather than calculating FCFE directly from its formulae.
Hope this post helps you in understanding the fundamentals about various methods of DCF. Keep ready to fly with me to experience the adventurous path of FCFF in my next post.