The premise behind discounted cash flow analysis is that the ﬁrm value or enterprise value (which is the value to both the debt and equity holders of a ﬁrm) should equal the present value of the perpetual free cash ﬂows of the company, discounted by the company’s weighted average cost of capital. Free cash ﬂow represents all of the cash inﬂows and outﬂows of a company excluding any ﬁnancing related charges such as interest payments to debt holders or dividend payments to equity holders.
Since DCF analysis is based on projected free cash ﬂows, great care must be taken in developing projections which are reliable, reasonable and which accurately reﬂect the most likely operating scenario for the company.
Discounted cash ﬂow analysis is considered the best method for calculating the intrinsic value of a company since value is calculated based on internally generated cash flows of the company, and those cash ﬂows are then discounted based on the inherent risks of those cash ﬂows. There are no “outside” forces in effect such as prices paid for other companies (as is the case with multiples based analysis) or the return required by a private equity investor (as is the case with leveraged buyout analysis).