Question

What are the most common DCF valuation models?

Discuss your understanding of Enterprise DCF and Discounted Economic Profit models. Explain what is similar and difference about them? What is the rationale for each? What are the benefits? Why is each model important?

What would you consider when deciding what to use?

Answer 1

What are the most common DCF valuation models?

DCF stands for discounted cash flow. Commonly used DCF valuation models are:

Under discounted cash flow analysis to value a business or a business segment or a business combination, we look at two different types of free cash flows:

1. Enterprise DCF where Free cash flow to the firm (FCFF) is discounted at WACC to get the value of Operations. FCFF is given by:

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This is post tax operating cash flow after capital expenditure.

2. Equity DCF where Free cash flow to equity holder (FCFE) is discpounted at cost of equity to get the value of equity directly. FCFE is given as:

If there is a preference share capital in the company, FCFE formula will also incorporate preferred stock dividend and will be given by:

FCFE is a cash flow which is free from all kinds of claims. It is a cash flow that ordinary equity holder can pocket safely. It’s the residual cash flow left after meeting all the liabilities, claims and investment needs of the company.

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Discuss your understanding of Enterprise DCF and Discounted Economic Profit models. Explain what is similar and difference about them? What is the rationale for each? What are the benefits? Why is each model important? What would you consider when deciding what to use?

Sl. No.	Parameter	Similarity /Difference	Enterprise DCF	Discounted Economic Profit
1.	Underlying cash flow	Difference	Free cash flows to the firm = EBIT x (1 - T) + Dep - Increase in working capital - Capital expenditure	Economic profit or residual income = NOPAT - charge on capital = NOPAT - WACC x Capital invested
2.	Discount rate	Difference	Weighted average cost of capital (WACC)	Weighted average cost of capital (WACC)
3.	Nature	Difference	Discounts an actual cash flow	Discounts an accrual income
4.	Output	Similarity	Gives value of the firm (Debt + Equity) as a whole	Gives value of the firm (Debt + Equity) as a whole
5.	Rationale	Difference	When you want to show capital requirement; surplus; shortfall, stable capital structure to the potential investor or shareholders	When you want to measure the true economic benefit, when you want to show value creation, when you want to show if firm is earning a return more than cost of capital, to the potential investors or shareholders
6.	Benefits	Similarity	Leads to valuation of the firm	Leads to valuation of the firm albeit by a different route. With some algebraic manipulation, it can be shown that Enterprise DCF and Economic Profit models are same thing.
7	Importance	Difference	Mostly to emphasize if the firm is in growth phase or stable phase? Is the firm still requiring cash or generating cash?	Emphasis on stability in earnings in excess of cost of capital, emphasis on value creation by the firm
8	Selection criteria	Difference	Most preferred model in industry primarily because it's based on cash flows going in the company and coming out of the company.	Relative less preferred, deals with accounting income rather than cash flows