DCF calculation - why isn't debt subtracted?

Hello everyone.

I have a short question, an answer would be highly appreciated!!

At the end of the DCF calculation (before you divide by shares outstanding): Why isn't debt subtracted and cash/cash equivalents added?

The DCF-Entity methode in general subtract debt and add cash/cash equivalents so why is it missing in the tool (and both books)?

Is it a minor mistake or intended?

Thank you in advance!

Regard,
Johnson

Comments

  • Hi Johanson,

    The reason debt is not subtracted and cash is not added is because the DCF model is not based upon the balance sheet(i.e. assets and liabilities) but is instead based upon future cash flows. As such we are instead using FCF, earnings growth and a given discount rate to determine intrinsic value. I hope this answers your question and if you have any further queries do not hesitate to ask!

    Regards,

    Anaximander
  • Hi Anaximander,

    First of all thank you very much for your answer!

    I am not quite there yet :-) Because DCF-Equity models using also FCF (and not the balance sheet). To make my point:

    https://en.m.wikipedia.org/wiki/Discounted_cash_flow

    As you can see in the picture (for example): From the discounted future cash flows debt is subtracted (and cash would be added).

    Or to put it in other words:

    If I would use the DCF-Calculator on the buffettsbooks webseite the result (before divided by shares outstanding) would be the exact same result as according to the DCF-Equity method EXCEPT the DCF-Entity method subtract the debt as mentioned above!

    No matter were I look (Internet, YouTube, Books) debt is always subtract at the end when one uses DCF to value a company!

    So my question still is:
    Why does the DCF-calculator leave this step out?

    Thanks in advance!!
  • Hi there Johanson,

    The DCF-Equity model you refer to is slightly different to the standard DCF model as it makes allowances for the cost of servicing the debt. In the basic DCF model future cash flows are the result of both equity and debt financing, one is basically estimating future cash flows based upon both equity and debt and future capital gains and then discounting them back to the present at a given rate. Take a look at this site which breaks the DCF model down and see if it clears things up for you.

    http://thismatter.com/money/stocks/valuation/discounted-cash-flow.htm

    Regards,

    Anaximander
  • edited June 5
    Hi Anaximander,

    thank you very much for the clarification! And thank you for the link, the website looks interesting!

    Regards,
    Johanson

    In case an Administrator see this:
    I DID'T GET THE CONFIRMATION EMAIL FOR THIS ACCOUNT! I used the resend button several times but I just don't get the email...
  • edited June 8
    Hi Johanson,

    Regarding your confirmation email... I sent you a PM.
  • Hi Johanson,
    Perhaps a more fuller explanation to your question is that there are 2 types of DCF models. You can estimate the firm's valuation using the Free Cash Flow to the Firm (FCFF) or using the Free Cash Flow to Equity (FCFE).
    This space doesn't allow me to provide the details of both methods but if used correctly both methods will generate the same result. If you are calculating the FCFF then once the value of the operating assets is determined then the amount of debt is subtracted & the amount of excess cash is added to leave the value of equity.
    In the case of FCFE the value of equity is calculated directly so there is no need to subtract the debt or add the excess cash. The FCFE approach requires the analyst to estimate the future Free Cash Flows remaining after all other claimants to the firm's cash have been paid. This can be tricky in situations where the firm's capital structure is changing over time. In these circumstances it is much easier to estimate the Free Cash Flows to the Firm.
    I suggest that a good reference book would provide a better & more detailed explanation.
    Best regards, Rob
  • Great comment Rob. Very insightful question Johanson!
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