Basic Model Components
A DCF valuation model must have the following basic components. Your model could have many more components, but it should include the components listed below.
- Historical performance figures
- Projected performance drivers (assumptions)
- Cash flow projections
- Valuation
- Supporting schedules
- Working capital projections
- Cost of capital computations
We have omitted many components to keep our model simple. The section below lists out some additional components you can add if needed. You should add them if your situation or case requires it. Generally unless required simpler is often better.
Components of More Advanced DCF Valuation Models
There are many features you can add to your model, if you have the time and need. Here is a list of features or sections you can add to your DCF valuation model if you need to.
Property, Plant & Equipment & Depreciation Schedules
We made the simplifying assumption that the capital expenditure and depreciation are a percentage of revenues. We could build one or more schedules to compute the capital expenditure and depreciation for different blocks of assets with different useful life. Capital expenditure can be based on other factors such as geographic expansion, age of machines, capacity utilization, projected growth, etc. Depreciation schedules can be built on MACRS depreciation schedules or other methods like the double declining methods in different asset blocks if this level of detail is required.
Sales to Capital Ratio
We modeled capital expenses as a percentage of revenues. Another way to model capital expenses is to study the historical sales to capital ratios of the firm or other companies in the industry and use the sales to capital ratio to model CAPEX investments.
Research & Development Expenses
We have modeled R&D expenses as a percentage of revenue and have expensed this. R&D expenses is a capital investment for the future and can be capitalized for some companies. We can model the impact of this capitalization if appropriate for your company.
Operating Leases vs. Capital Leases
The accounting standards in each country govern what is permitted to be expensed as an operating lease and what lease expenses must be capitalized. Valuation does not have any such constraints. The focus must be on cash flow.
Cost of Capital
We have assumed a single rate as the cost of capital. If you believe that the cost of capital will change over time, you can discount each year’s cash flows with the appropriate discount rate for that year. The discount rate may change over time due to many reasons such as a decline in risk, increasing competition, the maturing of the business, etc.
Many models also use a separate discount rate for the horizon period cash flows.
Employee Stock Options
Some companies hand out employee stock options (ESOP) generously to employees. This impacts the valuation of the equity and cash flow. It impacts equity value as the owners’ share of the business is reduced by the amount granted to the employees. Accounting regulations specify rules for dealing with ESOP. We need to model the cash flows from ESOP in the DCF valuation model if it is significant.
Time Periods/Fractional years
We have assumed that we are modeling the financial statements for whole years. You can model performance by months, quarters or half years if a more detailed view is required. Your years also need not start with a 12-month period. It could be more or less if your situation requires it.
Deferred Taxes, Tax Assets and Tax Liabilities
We have assumed a tax rate of 40% on pre-tax income in this simple model. You can model taxes separately featuring deferred taxes, tax assets, tax liabilities, loss carryforward, federal and state taxes, etc. if you have access to the appropriate details.
Investments: Subsidiary/Inter-co
Companies could have investment securities or investments in other firms including subsidiaries. These must be modeled separately and added into the final value if needed.
Minority Interest
Revenues and expenses of subsidiary companies are consolidated into a parent company’s financials according to the accounting regulations if certain conditions are met. This is true even if the parent company does not own 100% of the subsidiary. Minority interests must be valued and considered when valuing the entire business.
Equity Beta
We have assumed an equity beta. We can model the equity beta based on the historical stock prices and market returns if the company is a publicly listed company. If the company is not a publicly listed company, we can model the equity beta from the industry beta by studying comparable firms that are publicly listed.
Ingredients Required for a DCF Valuation Model
The key ingredients required to build a DCF valuation model are:
- Historical income statements;
- Historical balance sheets;
- A good understanding of the business’s operating characteristics; and
- Management plans for the immediate future.
Historical income statements and balance sheets provide a good base on which future performance drivers can be assumed or predicted. A good understanding of the business model and its operating characteristics such as the levels of inventory required, credit policies, etc. will help better estimate future performance drivers. Management plans for the immediate future are very important especially if expansion, new investments or changes in strategy or financial policy are expected because these impact projected cash flows. Most of the ingredients required to project cash flows required for a DCF valuation can be found in the company’s annual reports or in the company’s Form 10Ks. The section titled Management Discussion and Analysis (MD&A) in a company’s Form 10K is a good starting point. Information about management plans can be found in industry reports, earnings calls and media reports.