DCF is the abbreviation for Discounted Cash Flows, and the DCF method is an approach for evaluating projects, measures (such as restructuring) and entire companies. The DCF method is based on two postulates:
1. The value of a company or the value of a project is equal to the present value of all future free cash flows of the company or project.
2. Der Barwert der zukünftigen Freien Cashflows bei denen es sich um unsichere Größen handelt kann berechnet werden, indem zunächst die Erwartungswerte der zukünftigen Freien Cashflows aufgestellt werden. Diese erwarteten Freien Cashflows werden anschließend mit dem Cost of capital diskontiert und addiert. Der Kapitalkostensatz ist eine marktübliche Rendite und spiegelt das Risiko wider, also den Sachverhalt, daß die zukünftigen Freien Cashflows unsicher sind.
If the future cash flows for the years t = 1, 2, ... are denoted by C, the snake (tilde) indicates that the variables are uncertain and if the planned investments I,, I2, ... are subtracted from them, one obtains the free cash flows of the coming years (they are uncertain quantities with the cash flows). The owners, operators or shareholders of a project or a company receive, possibly after an initial investment, returns for the coming years, and they are given by the consequence of the risky amounts.
The value of the project or company (after the possibly required initial investment has been made) is the present value of the consequence of these risky free cash flows. In order to determine the present value, the expected values of the free cash flows are first calculated (and they are usually referred to as FCF).
It is also assumed that the present values of the uncertain future free cash flows are calculated by discounting the expected values of the free cash flows at a rate known as the cost of capital, which reflects the return that can be expected on the financial market with investments of comparable risk. Since the cash flows that have just been set up go in favor of the owners or shareholders, the cost of capital can be addressed more specifically than the cost of equity. Let this set be denoted by r.
The result is therefore the value of the project or the company in favor of the owners or shareholders, which is why the present value so formulated reflects the market value of equity.
The cash flows are taken from a business plan. In this way, it is not actually a company that is rated “in itself”, but a certain business plan. For example, management could evaluate two or three different reorganization or restructuring projects for their company and then choose the plan variant that is associated with the highest DCF.
Planned investments: As explained, those investments that are planned in the business plan are deducted from the cash flows so that the cash flows, as planned, become realistic.
New investments: In the course of time it should usually be the case that the company then invests even more. Because not all free cash flows are withdrawn. If the free cash flows are (partially) retained, then new investments are possible and a new, expanded plan can be drawn up. Free cash flows in a business plan can be withdrawn, reinvested, or used to repay debt. If they are reinvested, more can happen than was originally planned.
The cost of equity should be in line with the risks. Typical rates are in the range of 10% or 12% if the project or company can be viewed as a position that, like the stock of a blue chip, can be traded in a liquid financial market and has risks comparable to those of blue chips.