The DCF method of valuation is based on the belief that the value of a business equals the total discounted cash flows it generates.The main advantage of the DCF-method is that it values a firm on the basis of future performance. In other words: perfect for a startup that might not really have realized any historical performance yet. Numerous companies compare DCF value to market value to determine whether something is over or under-valued.
The Discounted Cash Flow method can often give us a much better measure of a project’s profitability, for three main reasons:
- DCF washes out year-to-year variations in profit and gives us a single valid figure for the whole life of the project.
- DCF automatically takes into account the timing of cash payments and receipts, so that no one can neglect the importance of this factor.
- DCF gets around the difficulty of interpreting what accountants mean by “profit” and gives us a simple, unambiguous definition based on project earnings over the entire life of a project.
A levered DCF forecasts FCF after interest expense (Debt) and interest income (Cash), whereas an unlevered DCF forecasts FCF before interest expense and interest income.
A levered DCF model, on the other hand, attempts to value the equity component of a company’s capital structure directly, whereas an unlevered DCF analysis attempts to value the company as a whole.
