DCF valuation models: Free cash flow, APV, ECF and CCF valuation models

Abstract

It is now a common practice to use discounted cash flow (DCF) models to value companies. The DCF models are based on the premise that profit itself does not tell us much. We must also take into account the investment required to generate the profits. Analysts who use DCF models have to choose from at least four approaches: free cash flow (FCF) to firm valuation, equity cash flow valuation, capital cash flow (CCF) valuation, and adjusted present value (APV). This chapter provides an overview of these approaches. This chapter has the following objectives: • Discuss calculation of FCFs • Discuss approaches for the estimation of terminal value • Discuss the four valuation approaches and their appropriate application The DCF methodology is widely used to evaluate capital projects. In the DCF approach, the value of the project is the future-expected cash flows discounted at a rate that reflects the risk of the projected cash flows. The DCF methodology is founded on the principle that it is inappropriate to capitalize earnings per se. One must also take into account the investment required to generate those earnings. Consequently, cash flows are obtained by deducting net capital expenditure and incremental working capital investment from net-operating profits after taxes (NOPAT). Since companies are portfolios of projects, the DCF approach is widely used in valuation of firms as well. © 2009 Springer-Verlag Berlin Heidelberg.