This is why we need to add back the depreciation and amortization charges. However, this $200 expense is not a cash flow because MakDonald has already paid the price of $1000 at the beginning (that payment was the cashflow). So every year, there will be a depreciation expense of $200. Although they are considered expenses from an accounting perspective (thus deducted in the net profit), theses are non-cash items as there is no actual cashflow involved.Ĭonsider this: MakDonald, a local restaurant bought a refrigerator two years ago for $1000 and the useful life of the refrigerator is 5 years. Step 1:Īdd back the depreciation and amortization charges. Generally speaking, there are three adjustments required to convert accounting profit into cashflow. Therefore what we need to do next is to convert our projected profits into projected cash flows. So bear in mind, in the world of valuation, only cash flow matters. So your accounting profit for this year would be $100k (assuming $0 cost for simplicity), but your cash flow would be $0. Consider a very simple example here: you sell a car for $100k, but the customer will pay you one year later. Accounting profits could be very different from the cashflow due to accruals, receivables, capitalized investments etc. Converting Accounting Earnings into CashflowsĪs indicated by its name, a DCF concerns only cashflows but not profits. Kindly note the Historical Financials are for reference only. In our example, the projection period is from FY2019 to FY2023, with 2023 being the terminal year.
#CASHFLOW ACADEMY HOW TO#
The terminal value is calculated in the terminal year and we will discuss more on how to do terminal value calculation later in this article. That is why we stress the importance of the business having matured and stabilized during the projection period. The terminal year assumes that a business will continue to generate cash flows at a constant stable rate forever. So you are probably thinking, if my Projection Period is only 5 years, how do I incorporate future cash flows (for the foreseeable future) into my DCF ? However you don’t want a projection period that’s too long (> 5 years) unless you have are confident on the expectations beyond this period. Ideally, you should set the projection period based on (i) the stage of the business and (ii) until the business has matured and stabilized. Some businesses may be able to forecast more accurately for even longer periods (say 10 years) because they have more predictable cashflows which could be due to signed agreements/concessions. That being said, since we cannot predict the future, most forecasts typically go up to 3-years or 5-years. Valuation best practice recommends the projection period to extend until the business has matured and growth stabilized.įor example, start-up businesses have high growth expectations and should incorporate a longer projection period as compared to a mature business. The projection period refers to the time period that your forecast covers. These expectations are built into the DCF as follows: 1. As we mentioned above, the DCF incorporates expected future cashflows into the valuation for the foreseeable future. Projection Period and Terminal Yearīusinesses are assumed to be a going concern (i.e., they operate into the foreseeable future). In our example, we set the Valuation Date to be 31 December 2018. Next you need to determine the Expected future cashflows from the Valuation Date onwards (since the DCF only incorporates future cash flows into the valuation). So the very first step is to determine the Valuation Date of your DCF. Microsoft excel or equivalent spreadsheet tools.ĭue to the time value of money, $1,000 today is worth more than $1,000 next year.Īlso, the DCF approach values a business at a single point in time (i.e., the Valuation Date).
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