Question

Discuss your understanding of Enterprise DCF and Discounted Economic Profit models. Explain what is similar and difference about them? What is the rationale for each? What are the benefits? Why is each model important?

What would you consider when deciding what to use?

Answer 1

Answers for your Query -

DCF means Discounted Cash Flow. The DCF valuation method is used to estimate the value of an investment based on its future cash flows. DCF analysis finds the present value of expected future cash flows and forecast of a company’s unlevered free cash flow to value as of today.

Discounted Economic Profit (DEP) is the portion of free cash flow which remains after a capital charge is subtracted. It works in much the same way as DCF. The crucial distinction in this case, is that the intrinsic value of the company is split into two parts. One represents invested capital, while the other represents the present value of future economic profits. This is often referred to as residual profit, or sometimes as excess earnings.

Similarities:

Both methods helps in corporate valuation.

Differences:

While DCF uses FCFF (Free Cash Flow to Firm), DEP valuation tracks each of the projected years based on the NOPAT (Net operating profit after tax) deducted by capital costs.

DCF shows clearer the cash flows of the firm annually. DEP based valuation has less estimation inputs and less calculating steps.

Rationale of DCF and DEP

The DCF is directly related to financial transactions that would allow converting future cash flows into present cash flows and vice versa.

DEP measures the company's financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis.

Benefits:

• Measure the effectiveness of capital utilization
• It helps to reveal and quantify the differing means of creating value for various industries and companies
• It helps to identify the signal market expectations
• Provide effective frameworks for various scenario and share value sensitivity analysis.

Importance of models:

DCF – It determines the present value of a company or asset based on the value of money it can make in the future. The purpose of DCF analysis is simply to estimate the money you'd receive from an investment and to adjust for the time value of money.

Discounted Economic Profit – It is important because it is used as an indicator of how profitable company projects are and therefore serves as a reflection of management performance.

Conclusion:

The Discounted Economic Profit valuation method seems to have more advantages since it is based on a simple concept, less estimating numbers and simpler to implement.