Discounted cash flow (DCF) is the student’s first introduction to business valuation. It involves multiyear forecasts and firm-specific discount rates. In determining what a buyer or seller should consider in the M&A pricing process, practitioners deemphasize DCF in favor of comparable public company and comparable acquisition approaches.
A company’s intrinsic value is the present value of its stream of future cash dividends. This value is calculated with different formulas, depending on the situation at hand, and many books describe DCF formulas under multiple scenarios. The simplest formula is used for firms that have a stable capital structure and a stable growth rate.
Discounted Cash Dividend Valuation Approach: Constant Growth Model
- P= Intrinsic value
- D1 = Next year’s cash dividend
- k= Annual rate of return required by shareholders. Note that this k relates solely to equity holders and is therefore different than the weighted average cost of capital (WACC).
- g= Expected annual growth rate of dividends
To calculate the intrinsic value, the practitioner plugs in the numbers for D1, k, and g. He derives D1 and g from his financial projections of the acquisition target. We discuss k later.
For companies that are not expected to have anything approaching a constant growth rate, such as a cyclical business, a start-up ...