Course 404: Putting DCF into Action
Step 1--Project Free Cash Flow
In this course
1 Introduction
2 Step 1--Project Free Cash Flow
3 Step 2--Determine a Discount Rate
4 Step 3--Discount Projected Free Cash Flows to Present
5 Step 4--Calculate Discounted Perpetuity Value
6 Step 5--Add It All Up
7 The Bottom Line

The first step in projecting future cash flow is to understand the past. This means looking at historical data from the company's income statements, balance sheets, and cash-flow statements for at least the past four or five years.

Once you've examined the historical data and perhaps entered it into a spreadsheet program, it's time to project the company's free cash flow in detail for the next couple of years. These projections are the meat of any DCF model. They will rely on your knowledge of the company and its competitive position, and how you expect things will change in the future. If you think profit margins will expand, or sales growth will slow dramatically, or the company needs to increase its capital expenditure to maintain its facilities, your projections should reflect those predictions.

Next, we need to estimate the company's "perpetuity year." This is the year at which we feel we can no longer adequately project future free cash flow. We also need to make a projection concerning what the company's free cash flow will be in that year.

To begin, let's suppose that the fictitious firm Charlie's Bicycles generated $500 million in free cash flow last year. Let's also assume that Charlie's current lineup of bikes are very hot sellers, and the company is expected to grow free cash flow 15% per year over the next five years. After five years, we assume competitors will have started copying Charlie's designs, eating into Charlie's growth. So after five years, free cash flow growth will slow down to 5% a year. Our free cash flow projection would look like this:

Last Year: $500.00
Year 1: 575.00
Year 2: 661.25
Year 3: 760.44
Year 4: 874.50
Year 5: 1005.68
Year 6: 1055.96
Year 7: 1108.76
Year 8: 1164.20
Year 9: 1222.41
Year 10: 1283.53

Next: Step 2--Determine a Discount Rate >>

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