Discounted Cash Flow

What is Discounted Cash Flow?

DCF full form is Discounted Cash Flow, is a method used to figure out the current value of an investment based on how much money it is expected to generate in the future. In simple terms, it looks at future cash flows how much money a business or investment will likely bring in and then discounts that future money back to what it would be worth in today’s terms. This helps investors or business owners understand whether an investment is worth pursuing today based on future profits.

For example, if you're considering buying a company or investing in stocks, DCF helps you see if the potential future returns are worth the investment today. It’s also useful for business owners when deciding on big projects or expenses like whether to expand a business or invest in new equipment because it provides a clearer picture of future returns compared to the initial cost.
 

How Does DCF Work?

DCF analysis helps estimate an investor's money received from the investment adjusted for the time value of money. Now, what do you mean by the time value of money? Simply put, it assumes that the dollar one has today can be worth more than one dollar received tomorrow because it can be invested. 

DCF analysis is valuable in any situation where an individual pays money in the present, expecting to get more money tomorrow.

With DCF analysis, one can find the present value of future cash flows via the discount rate. Also, investors may use the concept of present value to determine the cash flow of an investment in the future. 

The opportunity might be considered when the calculated DCF value is higher than the most recent investment cost. On the contrary, if the amount is lower than the cost, it can be a good opportunity. 

An investor can conduct the DCF analysis only after making future estimates with the ending value of the equipment, investment, or any other assets. An investor should determine the discount rate.

But note that the rate may vary based on the investment or project under consideration. Certain parameters also affect the discount rate, including the investor or company's risk profile, capital market conditions, etc.
 

Example of DCF

When a company is deciding whether to invest in a project or buy new equipment, it often uses the weighted average cost of capital (WACC) as a way to figure out if the project is worth it. The WACC tells the company how much return (percentage) it expects to make to satisfy shareholders.

For example, if a company's WACC is 5%, it will use that 5% as a discount rate to check if future cash flows from the project are worth more than the cost of starting it.

Let's say Mr. Shankar plans to invest ₹1,00,000 in a business for 5 years. The business has a Weighted Average Cost of Capital (WACC) of 6%. He expects the following cash flows from the investment over the years:

Estimated Cash Flows

Advantages and Disadvantages of Discounted Cash Flow

The main benefit of the DCF technique is that it is based on basic financial measurements rather than market opinion. 

Advantages:

Intrinsic Valuation: In contrast to market-based approaches, DCF determines a company's intrinsic value by considering its actual earning potential.

Customisation: Forecasts can be adjusted by analysts to account for company-specific risks, investment plans, and macroeconomic shifts.

Sensitivity Testing: By modifying forecast assumptions, terminal growth, and WACC, it permits thorough stress testing.

Utilisation in Unlisted Businesses:  vital for assessing private companies without comparables in the market.

Disadvantages:

High Sensitivity: Results might be disproportionately impacted by small adjustments to growth assumptions or discount rates.

Forecasting Challenges: Accurately predicting long-term cash flows is difficult, especially when looking beyond the next five to seven years.

Complexity: Necessitates a thorough comprehension of risk profiles, industry trends, and financing.

What is the Discounted Cash Flow DCF Formula?

The formula for calculating DCF is:

DCF = [Cash flow for the 1st year divided by (1 + r)1] plus [Cash flow for the 2nd year divided by (1 + r)2] plus [Cash flow for 3rd year / (1 + r)3] + .. + [Cash flow for the nth year divided by (1 + r)n]

Where:

●    Cash flow encompasses the outflows and inflows of funds
●    R symbolises the discount rate
●    N describes the additional or final years

To get an insightful and practical understanding – here's outlining an example.

Suppose Mr. Adnani wants to make an investment of ₹ 1.5 lakh in his startup retail business for a tenure of 5 years. The WACC of the business is 6%. So, the estimated cash flow can be the following:

Depending on the discounted cash flow formula:

DCF is equal to [25,500 / (1 + 0.06)1] + [20,000 / (1 + 0.06)2] + [24,500 / (1 + 0.06)3] + [36,500/ (1 + 0.06)4] + [43,500 / (1 + 0.06)5] 

So, the DCF for every year will be the following:
 

How to Calculate Discounted Cash Flow

The calculation of DCF entails two major components: the forecasted Free Cash Flows (FCFs) and the discount rate applied to them, usually the Weighted Average Cost of Capital (WACC).

Step-by-step Calculation:

• Forecast Free Cash Flows: Typically projected for 5 to 10 years. FCF = EBIT (1 - Tax Rate) + Depreciation & Amortisation - Capex - ΔWorking Capital.
• Determine the Terminal Value: Post-forecast, the company is assumed to grow perpetually at a stable rate (Gordon Growth Model) or be valued using an exit multiple.

Discount the Cash Flows: Using the formula:

Where TV is Terminal Value, and n is the final year of explicit projection.

• Sum of Present Values: Add the present values of projected FCFs and the discounted Terminal Value to get the enterprise value.
• Adjust for Net Debt: To get the equity value, subtract net debt from the enterprise value.

DCF models can also incorporate scenario analysis, Monte Carlo simulations, or probabilistic distributions to reflect a more realistic risk-return profile.
 

Where can the Discounted Cash Flow Method be Used?

Discounted Cash Flow (DCF) can be used to estimate the value of different things like:

A business: To figure out how much a company is worth by looking at its future cash flow.
Real estate: To determine the value of property based on future rental income or sale price.
Stocks: To estimate the value of a company's shares by predicting its future earnings.
Bonds: To value bonds by calculating future interest payments.
Long term assets: To value assets that provide returns over a long time, like machinery or factories.
Equipment: To assess the worth of equipment based on the future money it can help generate.

Difference Between DCF and NPV

While often used interchangeably, Discounted Cash Flow (DCF) and Net Present Value (NPV) serve distinct yet related purposes in financial analysis.

DCF refers to the valuation method where the present value of expected future cash flows is computed. It is a broader concept used in the valuation of companies, investments, or projects, and incorporates both equity and enterprise perspectives.

NPV, on the other hand, is a specific outcome derived from a DCF analysis. It represents the net value added by undertaking an investment, calculated as:

Key Differences:

• Scope: DCF is a methodological approach; NPV is a decision metric.
• Use Case: NPV is typically used in project finance or capital budgeting, whereas DCF is used in equity valuation or M&A.
• Output: DCF results in an intrinsic valuation (enterprise or equity value); NPV provides a go/no-go indicator based on whether NPV > 0.
• Understanding the distinction is crucial. A DCF can be used to calculate NPV, but the inverse is not always applicable.
   

Discounted Cash Flow Valuation

Discounted Cash Flow Valuation is a method used to estimate the value of an investment, company or asset based on its expected future cash flows. The idea is to determine how much those future cash flows are worth today, considering the time value of money (i.e., money now is worth more than the same amount in the future).

1. Future Cash Flows: First, you estimate how much cash the investment or asset will generate in the future. This could be yearly profits, income or savings.

2. Discount Rate: You then apply a discount rate to these future cash flows. The discount rate reflects the risk of the investment and the return required by investors. It's often the company’s Weighted Average Cost of Capital (WACC) or another appropriate rate.

3. Present Value: By applying the discount rate, you convert the future cash flows into today's value (called the present value). This tells you how much those future earnings are worth today.

4. Sum of Present Values: Finally, you add up all the present values of the future cash flows. This total is the estimated value of the investment or asset.
 

Pros and Cons of DCF Valuation

One of the main benefits of Discounted Cash Flow (DCF) is that it can be used to value many different types of companies, projects and investments as long as you can estimate their future cash flows.

DCF focuses on the intrinsic value of an investment meaning it gives you the true worth based on its own features without needing to compare it to other companies.

It also allows investors to create different scenarios like best case or worst case and adjust the cash flow estimates to see how their returns might change in various situations.

However, DCF has a few downsides. It's sensitive to changes in cash flow estimates, terminal value and the discount rate. Small changes in these can affect the result a lot. You also need to make many assumptions about future performance, which can make the analysis less reliable.

For innovative projects or fast growing companies, DCF might not work well because their future cash flows are harder to predict. In such cases, other methods like comparable analysis or precedent transactions are often better options.
 

DCF analysis with components

1. Cash Flow (CF): Cash Flow is the money an investor receives from owning an investment like stocks or bonds during a specific period. When creating a financial model for a company we often refer to it as unlevered free cash flow which shows the cash generated by the business before any debts are taken into account. For bonds, cash flow includes interest payments or money returned to the investor.

2. Discount Rate (r): The discount rate is used to determine the present value of future cash flows. In business valuations, it's usually the company's Weighted Average Cost of Capital (WACC) which reflects the return that investors expect from their investment. For bonds, the discount rate matches the bond's interest rate.

3. Period Number (n): Each cash flow occurs over a specific time frame which can be in years, quarters or months. These time periods can be the same or different and if they vary they are expressed as fractions of a year.
 

What is the Terminal Value in DCF?

When valuing a business, we usually look at its expected cash flows for the next five years. After that, we estimate a terminal value because it's challenging to predict how the business will perform far into the future.

There are two common ways to calculate this terminal value:

1. Exit Multiple: This method assumes the business will be sold after five years at a certain multiple of its earnings.
2. Perpetual Growth: This method assumes the business will keep growing at a steady, reasonable rate indefinitely. 

After forecasting cash flows for five years, we use one of these methods to estimate what the business might be worth in the long run.
 

Why is discounted cash flow Important?

Discounted cash flow (DCF) is important for several reasons:

1. Valuation Accuracy: DCF provides a more accurate valuation of a business or investment by considering the time value of money. Future cash flows are worth less today, so discounting them helps reflect their present value.

2. Investment Decision Making: Investors and analysts use DCF to assess whether an investment is worthwhile. If the present value of expected cash flows exceeds the investment cost, it may be a good opportunity.

3. Financial Planning: DCF helps businesses make informed decisions about budgeting, project funding, and capital expenditures. It allows companies to evaluate the potential profitability of various projects over time.

4. Comparison Tool: DCF can be used to compare different investment opportunities or business units, helping stakeholders decide where to allocate resources most effectively.

5. Risk Assessment: By adjusting the discount rate, analysts can account for different levels of risk associated with cash flows. This helps in understanding how changes in risk factors can affect valuations.

6. Long Term Focus: DCF emphasizes the long-term potential of an investment rather than just short term gains, encouraging a more sustainable approach to investing and business strategy.

Conclusion

Now you have learned valuation using discounted cash flows. Discounted cash flow is a way to figure out how much an investment is worth based on the money it’s expected to generate in the future. This method helps investors estimate potential profits by considering that money earned in the future is less valuable than money today.

To use DCF, you start by estimating future cash flows and then apply a discount rate to adjust those amounts for the time value of money. 

If the DCF value is higher than what you would need to pay for the investment, it suggests that the investment could be a good opportunity. DCF helps investors determine if they’re likely to make a profit from an investment by comparing its current cost to its expected future earnings.