Which is the first step in a Discounted Cash Flow model?

The first step in a Discounted Cash Flow (DCF) model is to project free cash flows for a specified period. This step involves analyzing the business's cash generation capabilities over a forecast period, which typically spans several years. During this phase, analysts estimate future revenues, expenses, taxes, changes in working capital, and capital expenditures to arrive at the net free cash flows.

Having a clear and realistic projection of free cash flows is critical because it serves as the foundation for the DCF analysis. Subsequent steps, such as calculating the present value of these cash flows and determining the terminal value, rely heavily on the accuracy of these projections. Inaccurate or overly optimistic cash flow estimates can significantly skew the valuation derived from the model, ultimately affecting investment decisions. Thus, starting with a robust projection of free cash flows is essential for an effective DCF analysis.