The Discounted Cash Flow method (DCF) assumes cash-flows that the company is expected to generate in the future. Those cash-flows originate from the operational results, as well as from the mutations in working capital, fixed assets, and provisions. The projected cash-flows are discounted on a ‘weighted average cost of capital’ basis. To the thus obtained net cash value, the market value of possibly available assets that are not necessary for business management is added, and the value of net interest bearing debt is deducted. This results in the market value of shareholders’ equity, or the value of the shares.
Theoretically, the DCF method is a correct valuation method. Accounting guidelines for annual reports do not influence the calculated value with this method. Of course, for a sound valuation thorough knowledge on the enterprise to be valued is necessary, as much as reliable prognoses.
The weakness of the DCF method lies in the way in which “cost of capital” is included in the calculation. At this, the DCF method is not only non-transparent, but also presumptions are necessary on a continuous debt/equity ratio that will often not apply in practice.