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Discounted Cash Flow: What is DCF? Formula, Examples, Pros & Cons
Cash is king, right? It’s a hard currency and arguably the truest measure of an investment’s value. Now, imagine a tool that allows you to peek into the future and see how much that cash - earned tomorrow - is worth today. That’s what Discounted Cash Flow (DCF) does.
In a world where cash rules, DCF is your guide to making sure every dollar, pound or euro counts - today and tomorrow.
In a world where cash rules, DCF is your guide to making sure every dollar, pound or euro counts - today and tomorrow.
FORMULA
Total DCF = Sum of discounted cash flows + Discounted Terminal Value
Big ideas
- If the total DCF is higher than the current cost of an investment, it means that it may be a profitable investment. But keep in mind that future cash flows can be disrupted.
- DCF is tied to the Time Value of Money (TVM) - the understanding that a pound today is worth more than a pound tomorrow, as it can earn returns in the meantime. This is why future cash flows are discounted at a specific rate, to account for the time value.
- The discounted cash flow is related to the Net Present Value (NPV) but it is not the same. The NPV lets you know whether or not an investment is profitable after taking discounted cash flows into account.
What is DCF?
The DCF is a widely used metric with multiple financial applications. It can help investors decide whether or not to purchase a company or security. It can also assist business owners with capital budgeting and operational expenditure.
DCF Formula
The idea is that money received today is worth more than money received in a year, because the money can earn a risk-free interest in the meantime.
The future cash flows of an investment are discounted based on a specific rate, usually the Weighted Average Cost of Capital (WACC). The discounted rate is applied due to the Time Value of Money (TVM), so the money (cash flows) received in future cannot be given a full value compared to money spent today.
After the discount has been applied to future cash flows, it is compared to the current cost of investment. If it’s above the present cost, then it could be a good investment. Otherwise, it is not worth it based on the DCF analysis.
The future cash flows of an investment are discounted based on a specific rate, usually the Weighted Average Cost of Capital (WACC). The discounted rate is applied due to the Time Value of Money (TVM), so the money (cash flows) received in future cannot be given a full value compared to money spent today.
After the discount has been applied to future cash flows, it is compared to the current cost of investment. If it’s above the present cost, then it could be a good investment. Otherwise, it is not worth it based on the DCF analysis.
Understanding the Discounted Cash Flow formula
Of course, to successfully apply the DCF formula, the discount rate needs to be accurate, as does the cash flow estimates. That’s easier said than done and in particular, the reliance on projected future cash flows is a major disadvantage of the formula since such cash flows can be interrupted for myriad of different reasons.
This is why DCF is best used in tandem with other valuation models.
This is why DCF is best used in tandem with other valuation models.
Components of the DCF formula
The DCF formula has three main components:
- Free cash flow (FCF) - This is the projected cash flow that a company generates after accounting for capital expenditures. It represents the cash available to investors.
- Discount rate - This rate (typically the WACC) adjusts future cash flows to their present value, reflecting the risk and time value of money.
- Terminal value - The value of all future cash flows beyond the forecast period, calculated using a perpetuity growth model or exit multiple.
The DCF formula sums the present value of projected FCFs and the terminal value to estimate the total value. This is then compared to the cost of investment to gauge whether or not it is worth entering into.
DCF calculation example
The formula for the DCF is simple to understand but timely to enact if there are a lot of future cash flows expected. You merely have to sum up all the discounted cash flows with the terminal discount rate.
Then you compare the end figure to the current cost of investment. If it’s higher than the investment amount, then it could be a profitable investment.
Then you compare the end figure to the current cost of investment. If it’s higher than the investment amount, then it could be a profitable investment.
EXAMPLE
Below is an example of discounted cash flows over 4 years. The upfront investment cost for the project is $525,000. This means that if the total DCF for the project is above $525,000, the investment should be profitable.
Free cash flow assumptions
• Year 1: $50,000
• Year 2: $60,000
• Year 3: $70,000
• Year 4: $80,000
• Discount Rate (WACC): 8%
• Terminal Value at Year 4: $500,000
Discounted cash flows
• Year 1: $50,000 / (1 + 8%)^1 = $46,296
• Year 2: $60,000 / (1 + 8%)^2 = $51,430
• Year 3: $70,000 / (1 + 8%)^3 = $55,562
• Year 4: $80,000 / (1 + 8%)^4 = $58,674
Discounted terminal value
• Terminal Value: $500,000 / (1 + 8%)^4 = $367,512
Total DCF value
• Total DCF = Sum of discounted cash flows + Discounted Terminal Value
• Total DCF = $46,296 + $51,430 + $55,562 + $58,674 + $367,512 = $579,474
So, the estimated value of the project using the DCF method is $579,474. In order to invest in this project, the initial cost needs to be less than $579,474.
Because the upfront investment cost is $525,000, the investment may yield nearly $55,000 in profit, as per the DCF analysis.
Free cash flow assumptions
• Year 1: $50,000
• Year 2: $60,000
• Year 3: $70,000
• Year 4: $80,000
• Discount Rate (WACC): 8%
• Terminal Value at Year 4: $500,000
Discounted cash flows
• Year 1: $50,000 / (1 + 8%)^1 = $46,296
• Year 2: $60,000 / (1 + 8%)^2 = $51,430
• Year 3: $70,000 / (1 + 8%)^3 = $55,562
• Year 4: $80,000 / (1 + 8%)^4 = $58,674
Discounted terminal value
• Terminal Value: $500,000 / (1 + 8%)^4 = $367,512
Total DCF value
• Total DCF = Sum of discounted cash flows + Discounted Terminal Value
• Total DCF = $46,296 + $51,430 + $55,562 + $58,674 + $367,512 = $579,474
So, the estimated value of the project using the DCF method is $579,474. In order to invest in this project, the initial cost needs to be less than $579,474.
Because the upfront investment cost is $525,000, the investment may yield nearly $55,000 in profit, as per the DCF analysis.
Common mistakes in DCF calculations
When calculating DCF, several common mistakes can occur, which basically boil down to using wrong estimates.
- Overestimating future cash flows is a frequent error, often due to overly optimistic assumptions about revenue growth or cost reductions.
This can lead to an inflated valuation.
- Another mistake is using an incorrect discount rate. If the discount rate doesn't accurately reflect the risk of the investment, the present value of future cash flows will be miscalculated.
- Ignoring changes in working capital or failing to account for necessary capital expenditures can also distort the DCF analysis.
- Additionally, incorrect treatment of terminal value - either by using an unrealistic growth rate or misapplying the formula - can significantly impact the final valuation.
- Finally, using outdated or irrelevant financial data can lead to inaccurate projections. Ensuring that all assumptions and inputs are based on current, realistic information is crucial for a reliable DCF calculation.
These mistakes can lead to poor investment decisions based on misleading valuations.
Examples of uses for the DCF formula
The DCF formula is a widely used model in finance for assessing the value of an asset, company, or project based on future cash flows. It’s particularly useful in scenarios where cash flows are predictable.
Business valuation
DCF is a fundamental method for business valuation. By projecting a company's future cash flows and discounting them to the present value, investors can estimate the company’s intrinsic value.
This is especially helpful for valuing companies with stable cash flows. The DCF method helps determine whether a company is undervalued or overvalued in the market. This can be crucial for mergers, acquisitions, and investment decisions.
This is especially helpful for valuing companies with stable cash flows. The DCF method helps determine whether a company is undervalued or overvalued in the market. This can be crucial for mergers, acquisitions, and investment decisions.
Investment analysis
Investors often use DCF to analyse potential investments. By calculating the present value of expected future cash flows from an investment, they can decide whether the investment offers a return that meets their required rate.
QUOTE
Warren talks about these discounted cash flows. I’ve never seen him do one.
For example, when evaluating a stock, DCF can help determine if the stock is trading below its intrinsic value, making it a good buy. It’s also used in comparing different investment opportunities, ensuring capital is allocated efficiently.
Project valuation
DCF is also commonly used in project valuation. When companies consider undertaking a new project, they need to evaluate its potential financial benefits.
By forecasting the project’s future cash flows and discounting them to the present value, decision-makers can assess whether the project will generate more value than it costs to implement. This helps in prioritizing projects and determining which ones may provide the best return on investment.
By forecasting the project’s future cash flows and discounting them to the present value, decision-makers can assess whether the project will generate more value than it costs to implement. This helps in prioritizing projects and determining which ones may provide the best return on investment.
Pros and Cons of the Discounted Cash Flow formula
The discounted cash flow is widely used, but it still has a number of flaws. For this reason, It is best used alongside other valuation tools.
Advantages of DCF analysis
✅ Future cash flow focus - DCF directly evaluates the value based on expected future cash flows, providing a detailed view of an investment’s potential. This method is beneficial for assessing long-term value and profitability.
✅ Flexible application - DCF can be adapted to various types of investments and projects. It allows for adjustments in cash flow projections and discount rates, making it versatile across different scenarios and industries.
✅ Objective valuation - by focusing on quantifiable cash flows and discount rates, DCF provides an objective measure of value. This reduces reliance on subjective market perceptions and helps in making data-driven decisions.
✅ Flexible application - DCF can be adapted to various types of investments and projects. It allows for adjustments in cash flow projections and discount rates, making it versatile across different scenarios and industries.
✅ Objective valuation - by focusing on quantifiable cash flows and discount rates, DCF provides an objective measure of value. This reduces reliance on subjective market perceptions and helps in making data-driven decisions.
Disadvantages of DCF analysis
❌ Dependence on projections - the accuracy of DCF heavily relies on the precision of cash flow forecasts. Overestimations or inaccuracies in projections can significantly distort the valuation outcome.
❌ Complexity in estimations - calculating the discount rate and estimating future cash flows can be complex and subjective. Small errors or assumptions can lead to significant valuation discrepancies.
❌ Sensitivity to discount rate - DCF results are highly sensitive to the chosen discount rate. Even slight changes in this rate can lead to substantial variations in the valuation, making the outcome less stable.
❌ Not ideal for all assets - DCF is less suitable for assets with unpredictable cash flows or for industries with high volatility. It may not be as effective for valuing startups or companies with irregular earnings.
❌ Complexity in estimations - calculating the discount rate and estimating future cash flows can be complex and subjective. Small errors or assumptions can lead to significant valuation discrepancies.
❌ Sensitivity to discount rate - DCF results are highly sensitive to the chosen discount rate. Even slight changes in this rate can lead to substantial variations in the valuation, making the outcome less stable.
❌ Not ideal for all assets - DCF is less suitable for assets with unpredictable cash flows or for industries with high volatility. It may not be as effective for valuing startups or companies with irregular earnings.
DCF vs NPV comparison
Net Present Value (NPV) adds one extra step to the DCF calculation to help you decide whether an investment is worth it. It represents the difference between what you get by using the DCF formula (i.e. the present value of future cash flows) and the initial investment cost.
If the NPV is positive, it indicates that the investment is expected to generate more value than it costs, making it potentially worthwhile.
In essence, DCF is the process used to evaluate an investment’s potential, while NPV provides a concrete measure of whether the investment adds value after accounting for its cost.
If the NPV is positive, it indicates that the investment is expected to generate more value than it costs, making it potentially worthwhile.
In essence, DCF is the process used to evaluate an investment’s potential, while NPV provides a concrete measure of whether the investment adds value after accounting for its cost.
Recap of Discounted Cash Flow (DCF)
Overall, the DCF method is a versatile tool in finance, applicable across various domains, from business valuation to investment to project analysis. By focusing on future cash flows, it provides a clear picture of an asset’s/project’s potential value, today.
It is, however, more of a foundational model than a comprehensive one. Relying on future cash flows is risky and other economic factors can easily disrupt these streams of income. DCF is more of an indicative analysis that sets the stage for further exploration. Furthermore, it relies nearly entirely on the cash flow projections being accurate.
The time value of money and the discounting of future cash flows are imperative to basic valuation and modern finance in general. But you won’t become Warren Buffett just by understanding these two key concepts.
It is, however, more of a foundational model than a comprehensive one. Relying on future cash flows is risky and other economic factors can easily disrupt these streams of income. DCF is more of an indicative analysis that sets the stage for further exploration. Furthermore, it relies nearly entirely on the cash flow projections being accurate.
The time value of money and the discounting of future cash flows are imperative to basic valuation and modern finance in general. But you won’t become Warren Buffett just by understanding these two key concepts.
FAQ on Discounted Cash Flow (DCF)
Q: Is DCF the same as NPV?
No, DCF is a method used to estimate the value of future cash flows by discounting them to the present. NPV (Net Present Value) is the result of applying the DCF method, showing the difference between the present value of cash inflows and the initial investment cost.
Q: Is IRR the same as DCF?
No, IRR (Internal Rate of Return) and DCF are different concepts. IRR is the discount rate that makes the net present value of cash flows equal to zero, while DCF is a method to calculate the present value of future cash flows using a discount rate.
Q: Why is DCF not used for banks?
DCF is less suitable for banks because their cash flows are complex and influenced by regulatory factors. Banks have significant interest income and expense, which can distort DCF calculations. Instead, valuation methods like price-to-earnings (P/E) ratios and price-to-book ratios are more common.
Q: Is WACC the discount rate?
Yes, WACC (Weighted Average Cost of Capital) is often used as the discount rate in DCF calculations. It reflects the average rate of return required by all of a company's investors, including equity holders and debt holders.
Q: Is DCF good for valuation?
Yes, DCF is a widely used valuation method because it provides a detailed analysis of the value of an investment based on expected future cash flows. It requires accurate cash flow projections and an appropriate discount rate to be effective.
- Perpetuity growth model: A method for estimating terminal value by assuming cash flows grow at a constant rate indefinitely.
- Exit multiple: A valuation approach that applies a market-based multiple to a financial metric at the end of the forecast period to calculate terminal value.
- Upfront investment cost: The initial outlay or amount required to start an investment project.
- Discounted Terminal Value: The present value of all cash flows expected beyond the forecast period, adjusted back to today’s terms using the discount rate.
- Present Value (PV): The current worth of expected future cash flows after applying a discount rate.
- Discounted Cash Flows: Future cash flows that have been adjusted to reflect their value in today’s terms using a discount rate.
- Weighted Average Cost of Capital (WACC): A company’s average cost of raising money from both debt and equity, weighted by how much of each source it uses in its financial structure.
