M＆A（Mergers and Acquisitions)

What is the DCF (Discounted Cash Flow) method?

Companies have a variety of assets, including cash and deposits. They also build up their assets using equity/other people’s capital. The value of a company lies in the cash generated by its assets. This is the case in the airline industry. In this way, the value of an individual company is calculated by calculating the sum of the present value of the future cash flows generated by its holdings. Below is a diagram of the cash flows.

In this way, the value of an enterprise (business) is determined by discounting the cash flows it will generate in the future by a discount factor of a certain value. In other words, the basis of the value of an individual company is determined by the assets that generate the cash flows (the debit side of the balance sheet). Conversely, in the airline industry example above, if companies A and B, which are almost identical businesses with similar asset structures, have very different business performance, the value of companies A and B will fluctuate due to the different discount factors used to discount the cash flows generated by the businesses.

FCF (free cash flow)

According to the above approach, if a company’s management wants to increase the value of the company, it must first of all maximise the cash flow, which is the numerator of the company’s value. Secondly, the denominator that discounts the cash flow generated by the business is the discount factor, so it is important to minimise this discount factor. In order to minimise the discount factor, the balance between asset risk and financial risk must be optimised, and in reality, there is a link between maximising cash flow and minimising the discount factor, so it is important to generate stable cash flow at a certain risk. This is why it is important to generate stable cash flows with a certain level of risk.

Calculating value using the DCF method

When you want to know the value of a company, we can calculate its value using the DCF method based on its financial statements, which is highly recommended for managers and stakeholders considering M&A. In addition, managers who want to sell their company in the future can calculate and understand the value of their company using the DCF method, which will lead to a higher sale price at the time of future sale.

M&A document ‘Compendium of successful mergers and acquisitions’