According company: (1) where CF = cash

According to Koller et
al. (2015), the amount of value a company creates is the difference between
cash inflows and the cost of the investments made, adjusted to reflect the fact
that tomorrow’s cash flows are worth less than today’s due to the time value of
money and riskiness of future cash flows. The DCF model is the most popular
among practitioners and academics because it focuses solely on the cash inflows
and outflows of the company, rather than accounting-based earnings. Gilbert
(1989) presents the generic DCF formula to value a company:

 

 

(1)

 

where  CF
= cash flow

i = discount rate

n = time periods from one
to infinity

 

To assess the intrinsic
value of an asset, three important steps are considered (Gilbert, 1989). The
first step accurately projects the cash flow items that contain periodic operating
earnings. The second step calculates the discount rate that represents the
returns earned on different investments encompassing similar risks (Luehrman,
1997). Finally, continuing value (CV) must be computed. Koller et al. (2015)
and Damodaran (2012) agree that predicting individual key value drivers yearly
becomes unfeasible, so a perpetuity-based formula is adopted. Herewith, the DCF
formula with CV can be written as:

 

 

(2)

 

In line with Oded and
Michel (2007), there are four common methods to value a firm using DCF: free
cash flow to the firm (FCFF), cash flow to equity, capital cash flow and
adjusted present value (APV). Moreover, Koller et al. (2015) propose the EP
model. The main differences between the methods are the measures of cash flow,
discount rates, and CV used. The authors agree that all these models yield the
same result.

Despite its high accuracy
and flexibility (Goedhart et al., 2005), the DCF method displays drawbacks. For
instance, if the resulting cash flows are negative, the value of the company
will be negative. As such, projections must be extended until a point in which
the cash flows become positive. However, this situation might not be possible
in the case of bankruptcy. Since bankruptcy costs need to be considered, the
extinction of the company is a possibility (Damodaran, 2012). Another special
situation has to do with cyclical companies, those whose earnings demonstrate a
repeating pattern of significant increases and decreases according to economic
expansions and contractions (Koller et al., 2015). Therefore, the effect of these
fluctuations must be incorporated in future cash flows (Damodaran, 2012).
Koller et al. (2015) suggest the use of scenarios for taking a systematic DCF
approach to valuing these firms. Lastly, if a company is changing its
structure, the value of assets, capital structure, and underlying risk must
change accordingly, which ultimately increases the uncertainty surrounding future
cash flows (Damodaran, 2012). It is based on this disadvantages that Luehrman
(1997) asserts that the “one-size-fits-all approach” is inefficient and that
the three crucial factors, “cash, timing and risk”, “one for each type of
valuation method” will surpass the DCF model.

I follow with a
presentation of the main DCF models: the enterprise-DCF, EP, and APV.