Challenges in Valuation by Using Discounted Free Cash Flow Method

Abstract

It is generally believed that, in determining the real value of a company, the best results are obtained by using the Dicounted FCF method. The overall value of the firm itself or the value of equity is determined by discounting the “appropriate” cash flows by “appropriate” discount rates. We basically need to determine three major parameters: free cash flows, cost of capital, and the terminal value. All these three parameters have sub-parameters within themselves. Because all these parameters and their sub-parameters are to be future values, many factors like the riskiness of the firm in question, its leverage ratio, whether it is a profitable firm, newly-established or public company will not only influence the calculation of these parameters/sub-parameters but will also make it more difficult for the analyst. This chapter explains what variables are needed for company valuation, how they are determined, and what problems may be faced in calculating these values. Finally, authors propose solutions to all the problems analysts will likely face.