What is the first step in a Discounted Cash Flow (DCF) analysis?

The first step in a Discounted Cash Flow (DCF) analysis is to project the company's free cash flows for a specific period, typically around five years. This is essential because the entire DCF framework relies on accurately estimating the cash flows that the business is expected to generate in the future. These projected cash flows comprise earnings before interest and taxes (EBIT), adjusted for capital expenditures and changes in working capital, to derive the free cash flows.

By focusing on this allocation of future earnings, analysts can effectively gauge the financial health and growth expectations of the company. Once these cash flows are estimated, they can then be discounted back to the present value using a discount rate, and the terminal value can be calculated to estimate the company's long-term growth beyond the projection period. This initial projection phase forms the foundation of a DCF analysis and is integral to determining the company's intrinsic value.