What is the first step in constructing a discounted cash flow (DCF) analysis?

The first step in constructing a discounted cash flow (DCF) analysis is to forecast unlevered free cash flows. This process involves projecting the future cash flows that a business is expected to generate, without taking into account any financial leverage from debt. This forecast serves as the foundation for the entire DCF analysis, as it provides the cash flows that will be discounted back to their present value.

Accurately estimating these cash flows requires a thorough understanding of the business's operational performance, including revenue growth, operating expenses, and capital expenditures. These forecasts are typically made for a certain period, often five to ten years, and are critical for establishing the value of the business based on its ability to generate cash in the future.

Once these cash flows are forecasted, analysts can then proceed to the subsequent steps of a DCF analysis, such as calculating the terminal value and discounting the cash flows to present value. Without the initial step of forecasting unlevered free cash flows, the rest of the analysis would lack a solid basis.