What is a discounted cash flow (DCF)?
Discounted cash flow (DCF) refers to a Evaluation method that estimates the value of an investment using its expected future cash flow.
DCF analysis attempts to determine the value of an investment today, based on projections of the amount of money that investment will generate in the future.
It can help those who are considering acquiring a business or buying securities to make their decisions. Discounted cash flow analysis can also help business owners and managers make capital budgeting or operating expense decisions.
Key points to remember
- Discounted cash flow analysis helps determine the value of an investment based on its future cash flows.
- The present value of expected future cash flows is obtained using a projected discount rate.
- If the DCF is higher than the current cost of the investment, the opportunity could result in positive returns and may be attractive.
- Companies typically use the weighted average cost of capital (WACC) for the discount rate because it takes into account the rate of return expected by shareholders.
- A disadvantage of DCF is that it relies on estimates of future cash flows, which may turn out to be inaccurate.
Discounted cash flow (DCF)
How does discounted cash flow (DCF) work?
The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the the time value of money.
The time value of money assumes that a dollar you have today is worth more than a dollar you will receive tomorrow because it can be invested. As such, a DCF analysis is useful in any situation where a person pays money in the present with expectations of receiving more money in the future.
For example, assuming an annual interest rate of 5%, $1 in a savings account will be worth $1.05 per year. Similarly, if a $1 payment is delayed for a year, its present value is 95 cents because you cannot transfer it to your savings account to earn interest.
The discounted cash flow analysis reveals current value expected future cash flows using discount rate. Investors can use the concept of the present value of money to determine whether future cash flows from an investment or project are greater than the value of the original investment.
If the calculated DCF value is higher than the current cost of the investment, the opportunity should be considered. If the calculated value is lower than the cost, it may not be a good opportunity. Or, more research and analysis may be needed before moving forward.
To perform a DCF analysis, an investor must make estimates about future cash flows and the ultimate value of the investment, equipment, or other asset.
The investor should also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment being considered. Factors such as the company’s or investor’s risk profile and capital market conditions may affect the discount rate chosen.
If the investor cannot estimate future cash flows or the project is very complex, the DCF will not have much value and alternative models should be used.
For DCF analysis to be useful, the estimates used in the calculation should be as robust as possible. Incorrectly estimated future cash flows that are too high can lead to an investment that may not be sufficiently profitable in the future. Similarly, if future cash flows are too low due to rough estimates, they may make the investment appear too expensive, which could lead to missed opportunities.
Discounted cash flow formula
The formula for DCF is:
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First year cash flow
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Cash flow for the second year
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The discount rate
\begin{aligned}&DCF = \frac{ CF_1 }{ ( 1 + r ) ^ 1 } + \frac{ CF_2 }{ ( 1 + r ) ^ 2 } + \frac{ CF_n }{ ( 1 + r ) ^ n } \\&\textbf{where:} \\&CF_1 = \text{The cash flow for the first year} \\&CF_2 = \text{The cash flow for the second year} \\&CF_n = \text{The cash flow for years} \\&r = \text{The discount rate} \\\end{aligned} Dheart rate=(1+r)1VSF1+(1+r)2VSF2+(1+r)notVSFnotwhere:VSF1=First year cash flowVSF2=Cash flow for the second yearVSFnot=The cash flow for the additional yearsr=The discount rate
Example of DCF
When a company analyzes whether it should invest in a certain project or buy new equipment, it generally uses its weighted average cost of capital (WACC) as the discount rate to value the DCF.
The WACC incorporates the average rate of return that the company’s shareholders expect for the given year.
For example, suppose your company wants to start a project. The company’s WACC is 5%. This means that you will use 5% as the discount rate.
The initial investment is $11 million and the project will last five years, with the following estimated cash flows per year:
| Cash flow | |
|---|---|
| Year | Cash flow |
| 1 | $1 million |
| 2 | $1 million |
| 3 | $4 million |
| 4 | $4 million |
| 5 | $6 million |
Using the DCF formula, the calculated discounted cash flows for the project are:
| Discounted cash flow | ||
|---|---|---|
| Year | Cash flow | Discounted cash flow (in nearest $) |
| 1 | $1 million | $952,381 |
| 2 | $1 million | $907,029 |
| 3 | $4 million | $3,455,350 |
| 4 | $4 million | $3,290,810 |
| 5 | $6 million | $4,701,157 |
Adding all the discounted cash flows gives a value of $13,306,727. Subtracting the initial investment of $11 million from this value yields a actual net value (NPV) of $2,306,727.
The positive number of $2,306,727 indicates that the project could generate a return greater than the initial cost, or a positive return on investment. Therefore, the project may be worth doing.
If the project had cost $14 million, the NPV would have been -$693,272. This would indicate that the cost of the project would be greater than the expected return. So, it might not be worth doing.
Dividend discount models, such as the Gordon’s growth model (GGM) to value stocks, are other examples of analysis that use discounted cash flows.
Advantages and disadvantages of DCF
Advantages
Discounted cash flow analysis can give investors and companies an idea of the merits of a proposed investment.
It is an analysis that can be applied to a variety of investments and capital projects where future cash flows can be reasonably estimated.
Its projections can be modified to provide different results for various hypothetical scenarios. This can help users account for the different projections that might be possible.
Disadvantages
The main limitation of discounted cash flow analysis is that it involves estimates and not actual numbers. Thus, the result of DCF is also an estimate. This means that for the DCF to be useful, individual investors and companies must correctly estimate a discount rate and cash flows.
In addition, future cash flows depend on various factors, such as market fluctuations request, the state of the economy, technology, competition, and unforeseen threats or opportunities. These cannot be quantified exactly. Investors need to understand this inherent downside to their decision-making.
The DCF should not necessarily be used exclusively, although strong estimates can be made. Companies and investors should also consider other known factors when evaluating an investment opportunity. In addition, comparable company analysis and precedent transactions are two other common valuation methods that could be used.
How to calculate DCF?
There are three basic steps to calculating DCF. First, predict the expected cash flows from the investment. Second, select a discount rate, usually based on the cost of financing the investment or the opportunity cost presented by alternative investments. Third, discount the projected cash flows to today, using a financial calculator, spreadsheet, or manual calculation.
What is an example DCF calculation?
You have a 10% discount rate and an investment opportunity that would earn $100 per year for the next three years. Your objective is to calculate the value today – the present value – of this flow of future cash flows.
Since money in the future is worth less than money today, you reduce the present value of each of these cash flows by your 10% discount rate. Specifically, year one cash flow is worth $90.91 today, year two cash flow is worth $82.64 today, and year three cash flow is worth $75.13. today. Adding up these three cash flows, you conclude that the DCF of the investment is $248.68.
Is the discounted cash flow the same as the net present value (NPV)?
No, it is not, although the two concepts are closely related. NPV adds a fourth step to the DCF calculation process. After forecasting the expected cash flows, selecting a discount rate, discounting those cash flows and totaling them, the NPV then deducts the initial cost of the investment from the DCF. For example, if the purchase cost of the investment in our example above was $200, the NPV of that investment would be $248.68 minus $200, or $48.68.