Discretionary cash flow is an important metric used for valuing companies. It represents the cash generated after paying all costs required to maintain the company’s current cash flows. It is essentially the cash which management is free to spend as they see fit.
DCF = OCF – Cn
DCF – Discretionary Cash Flow
OCF – Operating Cash Flow
Represents the cash generated by the business from it’s normal business operations. It is generally calculated by taking net earnings and adjusting for both non-cash items such as depreciation and cash changes not reflected in earnings such as changes in working capital.
Cn – Non-discretionary Capital Costs
Represents the capital expenditures the company needs to make in order to maintain their cash flow. For example, let’s consider a shipping company which needs to replace an older vessel. When they purchase the new ship and replace the old one, they have not increased their shipping capacity. Therefore this is a capital expenditure that they needed to make in order to maintain their cash flow rather than grow it.
Determining Non-discretionary Capital Costs is often the most difficult aspect of calculating discretionary cash flow because it involves detailed analysis of the company’s capital expenditures and often several assumptions. A very conservative approach that might be appropriate when there are no large capital expenditures is the utilization of Free Cash Flow. That is, deducting all capital costs from operating cash flows.
Importance for Valuation
In order to understand why discretionary cash flow is important for valuation purposes, we should consider the main factors which drive the value of a stock for investors:
- The underlying net assets of a business – when you buy a share of a company, you are now a part owner of the assets and liabilities of that company. Your hope is that the net assets (assets less liabilities) of the company grows, resulting in your shares being worth more on the open market.
- Dividends – companies can also choose to pay dividends to their investor. These dividends will decrease the net assets of the company but provide you capital which can be reinvested in the company or invested elsewhere.
As discussed above, Discretionary Cash Flow is the metric which shows us how much cash is available for new assets, payment of liabilities or payment of dividends. This is why it is considered to be the metric best suited to calculate the value of a company.