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.