Mastering financial modelling: Your comprehensive guide to building a DCF model from scratch

Written by Fmi.Online

Building a DCF Model from Scratch: A Step-by-Step Guide

A Discounted Cash Flow (DCF) model is a financial model used to value investment by estimating its future cash flows and discounting them back to their present value. It is one of the most popular valuation techniques used by investment bankers, financial analysts, and equity researchers to value companies, projects, and other investment opportunities. In this article, we will provide a step-by-step guide on how to build a DCF model from scratch.

Step 1: Understand the Basics of a DCF Model

Before building a DCF model, it is important to understand the basic components that make up the model. A DCF model is composed of three main sections: Cash Flow Projection, Discount Rate, and Terminal Value. The cash flow projection estimates the expected cash flows generated by the investment over a specified period, while the discount rate is the rate at which future cash flows are discounted to their present value. The terminal value is the value of the investment at the end of the projection period and is calculated using a terminal value multiple.

Step 2: Build a Cash Flow Projection

The first step in building a DCF model is to build a cash flow projection. This is done by forecasting the future cash flows generated by the investment over a specified period. The period could be five years, ten years, or more, depending on the investment being valued. The cash flow projection should include all relevant cash flows, including revenue, operating expenses, capital expenditures, and taxes.

To build a cash flow projection, start by gathering historical financial statements of the company or investment being valued. Use the historical data to estimate future revenue growth rates, operating margins, and capital expenditures. Once you have estimated the key inputs, build a detailed projection of future cash flows over the specified period.

Step 3: Determine the Discount Rate

The next step is to determine the discount rate to be used in the DCF model. The discount rate is used to discount future cash flows back to their present value. The discount rate should reflect the risk associated with the investment being valued. A higher-risk investment will require a higher discount rate, while a lower-risk investment will require a lower discount rate.

To determine the discount rate, start by estimating the risk-free rate. The risk-free rate is the rate of return on a risk-free investment, such as a U.S. Treasury bond. The risk-free rate serves as a benchmark for the discount rate. Next, estimate the market risk premium, which is the additional return required by investors to invest in a risky investment compared to a risk-free investment. Finally, estimate the beta of the investment, which measures the volatility of the investment compared to the overall market. The formula for the discount rate is:

Discount Rate = Risk-Free Rate + Beta x Market Risk Premium

Step 4: Calculate the Terminal Value

The next step is to calculate the terminal value. The terminal value represents the value of the investment at the end of the projection period. To calculate the terminal value, you can use the Gordon Growth Model or the Exit Multiple Method.

The Gordon Growth Model assumes that the company will continue to grow at a constant rate indefinitely. To calculate the terminal value using the Gordon Growth Model, use the following formula:

Terminal Value = (Cash Flow in the Final Year x (1 + Growth Rate)) / (Discount Rate – Growth Rate)

The Exit Multiple Method assumes that the company will be sold at a multiple of earnings or cash flow. To calculate the terminal value using the Exit Multiple Method, use the following formula:

Terminal Value = (EBITDA x Exit Multiple)

Step 5: Discount Future Cash Flows

The final step is to discount the future cash flows and the terminal value back to their present value. To do this, multiply each future cash flow by the appropriate discount factor, which is calculated using the discount rate. The discount factor for year n is calculated as:

Discount Factor = 1 / (1 + Discount Rate)^n

Once you have calculated the discount factor for each year, multiply it by the corresponding cash flow to calculate the present value of each cash flow. Add up the present value of all the cash flows to arrive at the net present value (NPV) of the investment.

Step 6: Sensitivity Analysis

Sensitivity analysis is a crucial step in building a DCF model. It involves changing the key inputs of the model to see how they affect the NPV of the investment. By doing sensitivity analysis, you can identify the key drivers of the investment’s value and assess the impact of changes in those drivers.

For example, you can test the impact of different revenue growth rates or different discount rates on the NPV of the investment. This analysis will help you to understand the risks associated with the investment and to make informed investment decisions.

Step 7: Conclusion

In conclusion, building a DCF model requires a thorough understanding of the basic components of the model, including cash flow projections, discount rates, and terminal values. By following these seven steps, you can build a DCF model from scratch and use it to value an investment. However, building an accurate DCF model requires a deep understanding of finance, accounting, and Excel, as well as the ability to make informed assumptions and conduct sensitivity analysis.

To gain a more comprehensive understanding of financial modelling and DCF models, it is recommended to take a course in financial modelling. FMI’s Introduction to Financial Modeling course is an excellent resource for students who wish to get into investment banking. The course covers the basics of financial modelling, including DCF models, and provides hands-on training in Excel. By taking this course, students can develop the skills they need to build accurate financial models and make informed investment decisions.

In conclusion, building a DCF model requires a lot of skill and practice, and this guide provides an overview of the key steps involved. Taking a course in financial modelling, such as the one offered by FMI, can help students develop the skills they need to build accurate financial models and succeed in the world of investment banking.

More Articles

How to Build a Successful Career in Asset Management: Tips and Strategies for Finance Students

In this article, we will explore some tips and strategies that can help finance students build a successful career in asset management.

Asset Management

The Art of Cracking Technical Interviews for an Asset Management Role at Top Banks

Asset management is the practice of studying, acquiring, and trading investments with an aim of increasing total wealth over time. The sector offers lucrative opportunities with sizable salaries for you to pursue. Asset managers are often referred as portfolio managers or financial advisors as they perform this service for their clients. Asset management companies are […]

Asset Management

Top 5 Asset Management Career Paths and How to Get Into Them

In an era of wealth preservation, product innovation, and creation of alternative asset classes, asset management (AMC) is emerging as a promising career path. The global asset management industry is estimated to grow and reach a value of over a trillion dollars, \$1,113 billion, by 2028, growing at a CAGR of over 23% for 6 […]

What maketh an Analyst?

Last August, I got the chance to mentor a student based in Singapore and he’s waiting for his graduation. We started on which type of career he wants, and I asked him about his background. Fortunately, he was trading Foreign Exchange.  It’s a good thing that he already understands Technical Analysis, and we got connected […]

Role of a Fund Manager and How You Can Get Into It

A fund manager is an investment professional responsible for investing and managing a company’s portfolio of funds. This can include mutual funds, pensions, hedge funds, equity funds and so on.  Fund managers are typically classified as active or passive managers. Active managers are involved in buying, selling, and holding investments actively in order to outperform […]

3 Ways Finance Simulations Can Help You Acquire Skills and Knowledge Quickly

If you have tried working with any aspects of financial markets, be it professionally or by investing in stocks, you would know that this field isn’t the easiest to understand theoretically. What you need is to learn by doing. This is possible through finance simulations.  These are mockups of a financial concept, created using mathematical […]

Understanding the Difference Between Tangible and Intangible Assets

An asset is something of value which is owned by a company. For companies, assets can be classified in different ways. For example, assets owned by a company can be current assets or non-current assets. Another way to classify assets are as tangible assets and intangible assets. This second way of classifying assets is the […]

Investment Banking

We often hear roles described as either “sell side” or “buy side.” This article aims to demystify the language around these terms and explain specific roles on the sell-side.

Our Courses are designed to boost your career

Launch your career with Fmi’s Learning Pathway

Choose a learning pathway that best meets your needs and ambitions. Not sure which Fmi learning pathway is right for you? Explore our CareerBuddy videos for help and advice.

Investment banking pathway

Monthly Subscription
• 60+ hours
• 9 courses

Investment banking offers many exciting career opportunities for students. From Financial Analysts to Investment Management, and Sales & Trading to a wide range of roles in infrastructure such as IT, Risk or Compliance. This pathway is designed to help you understand the investment banking industry, the roles investment banks are recruiting for, and most importantly, help you to develop the practical skills you need to get into the industry and your preferred role whether this be as part of a school leaver, intern or graduate program.

55,000+ students currently enrolled

Global markets pathway

Monthly Subscription
• 70+ hours
• 10 courses

Global markets provide a range of important products and services to corporates, institutions and governments worldwide from executing trades and managing risk to providing quality research content. A key business area in all investment banks, global markets offers a wide range of career paths for students to consider across all functions and at all levels from school leavers to internships through to graduate programs.

85,000+ students currently enrolled

Asset management pathway

Monthly Subscription
• 50+ hours
• 8 courses

The asset management industry is a global industry worth over 100 trillion US dollars. It plays a crucial role in managing the assets of retail and institutional investors, offering a wide range of exciting careers in doing so. If you’re looking to forge a career in asset management, our Asset management pathway is perfect for you. We help you build the skills all asset managers are looking for and explore everything you need to know about the industry and the wide range of roles available in the sector

100,000+ students currently enrolled