What is the first step in the discounted cash flow calculation?

The first step in a discounted cash flow (DCF) calculation is to project free cash flows for several years. This step is crucial because the DCF analysis relies on estimating the future performance of the company in terms of cash generation. By projecting free cash flows, you are estimating the cash available to the company after accounting for capital expenditures and working capital needs. This projection typically spans a forecast period of around 5 to 10 years.

Once the free cash flows are projected, they can be discounted back to present value using an appropriate discount rate, which reflects the risk of the investment. The calculation of terminal value, the application of the discount rate, and adjusting for net debt are subsequent steps that build upon the initial projections of free cash flows. Without these initial projections, the subsequent steps cannot be accurately completed, making this the foundational element of a DCF analysis.