Valuation of a company by discounted cash flow: 5 key steps

When it comes to making a valuation of a company For discounted cash flow valuation, it should be borne in mind that a simple long-term financial projection is not enough. In order to achieve a correct and consistent valuation, certain steps must be followed.

1) Historical and strategic analysis of the company and the sector

On the one hand, the first thing to look at is the company itself and the sector. When it comes to look at the companyIn the case of the latter, a thorough financial analysis must be carried out, in which the following factors must be observed:

• Profit and loss account and balance sheets: The most important thing here is to know whether the company is generating profits, what is the historical growth of the company and which levers are defining these results.
• Evolution of the flows generated by the company: Because this method of valuation is mainly based on cash flows, it is very important to know where these flows come from and whether they are sustainable over time.
• Development of the company's investments: Considering that investments are the engine for sustaining growth in sales and, in many cases, in future cash flow generations, it is very important to know what is usually invested in, how much it is capable of generating and the need for periodic investments.

In addition to these, the development of the company's financing, the analysis of the company's financial health and the weighting of the company's current risk are other key factors that differentiate a good financial valuation from a bad one.

Once this section has been completed, it is important to proceed with a strategic and competitive analysisThis means knowing the company and the sector inside out.

In this case, knowledge of the sector, of the main players, key drivers that are affecting the evolution of the sector are a good way to start.

This analysis should then be followed by identifying the value chain, understanding the company's capabilities and competitive position in order to understand the company's environment, the functioning of the industry and the current situation of the company in relation to its competitors.

2) Projections of future flows

Once the guts of the company and the sector are known, the next step comes from projecting the company's future cash flows. This requires forecasts of the industry, the company's competitive position and that of its competitors.

Once this has been done, it is possible to have an understanding of the situation that the company may face in the future, which will then be used to make financial forecasts.

These financial projections should be made on all three financial statements, cash flow, balance sheet and income statementThe main emphasis is placed on planned investments, financing and cash flow generation capacity, and this section is concluded after the calculation of the terminal value of the investment.

In this step, it is very important to have certain scenarios in place, in order to be able to see how different variations in inputs may affect the company and to be able to create contingency plans that help to redesign the strategic plan in case of worse than expected situations.

Finally, this type of projections should be reviewed to see if

have a certain consistency, thus avoiding under- or over-weighting. To this end, it is important to compare these projections with forecasts of historical figures and the historical ability to deliver on the company's strategy, among others.

3) Determining the cost of resources

Once the projections have been set up, it is important to be aware of what is the required profitability for each business unit and for the company as a whole.

This takes into account both the cost of debt and the required return on equity, i.e. it is calculated as follows the weighted average cost of resources. A calculation that must be made with great care as a slight variation can alter the final valuation result.

4) Updating of future flows

In this section only the expected flows and the residual present value are discounted to the corresponding weighted average cost, thus obtaining the present value of investments.

5) Interpretation of results

Once the valuation of a company has been carried out benchmarking is carried out with similar companies to see if it makes sense or if an imputation needs to be revised, or if it serves as a "sanity check".

In addition, it is important to identify what the expected value creation is and the horizon over which it could continue to create value, how sustainable it is and which threats need to be further monitored.

A well-crafted sensitivity analysis in this section usually provides a great deal of value in terms of knowing what can happen according to the different scenarios previously considered, giving greater certainty about the valuation.

Finally, it is important to be able to justify on what strategy underpins this planned value creation and to try to guide managers to maximise this creation.