How do you incorporate capital expenditure into a discounted cash flow (DCF) analysis?

1 Define capital expenditure

Capital expenditure, or capex, is the amount of money that a business invests in long-term assets, such as property, plant, equipment, or intangible assets, such as patents or trademarks. Capex is different from operating expenses, or opex, which are the ongoing costs of running the business, such as salaries, rent, utilities, or marketing. Capex is usually considered as an investment that generates future benefits, while opex is usually considered as an expense that reduces current profits.

2 Calculate free cash flow

Free cash flow (FCF) is the cash that a business generates from its operations, after deducting the cash needed for capital expenditure. FCF is the key input for a DCF analysis, as it represents the cash available to the owners or investors of the business. To calculate FCF, you need to start with the operating cash flow (OCF), which is the cash generated from the core activities of the business, such as selling goods or services, paying suppliers, or collecting receivables. Then, you need to subtract the capital expenditure, which is the cash spent on acquiring or maintaining fixed assets. The formula for FCF is:

FCF = OCF - capex

4 Discount future cash flows

The final step in a DCF analysis is to discount the future cash flows of the business, using a discount rate that reflects the risk and return of the investment. The discount rate is also known as the weighted average cost of capital (WACC), which is the average rate of return that the business needs to pay to its debt and equity holders. The higher the discount rate, the lower the present value of the future cash flows. The formula for discounting future cash flows is:

Present value (PV) = FCF / (1 + WACC)^n

where n is the number of years in the forecast period.

To calculate the present value of the terminal value, you need to use the same discount rate and divide it by the difference between the discount rate and the terminal growth rate. The formula for discounting terminal value is:

PV of terminal value = terminal value / (WACC - terminal growth rate)

5 Add up present values

The final step in a DCF analysis is to add up the present values of the future cash flows and the terminal value, to get the enterprise value (EV) of the business. EV is the total value of the business, including its debt and equity. To get the equity value, or the value of the shares, you need to subtract the net debt (debt minus cash) from the EV. The formula for equity value is:

Equity value = EV - net debt

To get the value per share, you need to divide the equity value by the number of shares outstanding. The formula for value per share is:

Value per share = equity value / number of shares

6 Here’s what else to consider

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