The importance of this method stems from a golden financial rule: "A riyal today is worth more than a riyal tomorrow." Discounted cash flows are an attempt to read the future with the eyes of the present, by estimating the money the company will generate in the future, and then "discounting" it to reach its present value.
1. Essential Components of the Model
To build a robust DCF model, focus must be on three core variables:
- Free Cash Flow: The liquidity remaining for the company after paying all operating costs and capital investments necessary to continue growth. It is the "real cash" available to investors.
- Discount Rate: Often the "Weighted Average Cost of Capital" (WACC) is used. This rate reflects risks; the higher the investment or sector risks, the higher the discount rate, reducing the company's present value.
- Terminal Value: Represents the company's value after the forecast period (usually 5-10 years), assuming it will continue to grow at a constant rate forever.
2. Valuation Steps (Consulting Path)
The valuation process is not just a mathematical equation, but a series of logical assumptions:
- Forecasting: Building future financial forecasts based on historical performance and strategic plans.
- Calculating Flows: Determining net free cash flows for each forecast year.
- Aggregation: Adding the present values of the flows with the terminal value to reach the Enterprise Value.
3. Why do Governance and Investment Experts Prefer It?
Unlike Price-to-Earnings ratios (P/E Ratios) which may be affected by accounting treatments, DCF focuses on cash:
- Materiality: Looks at the company's real ability to generate liquidity.
- Flexibility: Allows consultants to test different scenarios (Optimistic vs. Pessimistic).
- Independence: Does not rely entirely on momentary market fluctuations, but on the company's intrinsic operational factors.