Definition
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values. The sum of all future cash flows, both incoming and outgoing, is the net present value, which is taken as the value of the cash flows in question.
Discounted Cash Flow
Discounted Cash Flow (DCF) is a financial tool that is used to evaluate investment opportunities. The technique makes use of future cash flow projections and expected rate of return to determine present value of an investment. This expected rate of investment is the discount rate that is most usually the weighted average cost of capital (WACC).
Main purpose of the DCF analysis is to determine the estimated amount of money adjusted to the present value that the investor will receive if an investment is made in a particular asset. The present value of different investment options is compared to make informed financial decisions.
How DCF is Calculated?
DCF is calculated using the formula given below.
DCF = Cash Flow1 / (1+r)1 + Cash Flow2 / (1+r)2 + ……. + Cash Flown / (1+r)n
An opportunity is considered to be good if the DCF value is greater than the original investment value. Opposite is the case if the DCF value is less than the original investment amount. A simple example can help in further clarifying this concept.
Suppose that a company wants 9% growth from an investment. This is the discount rate of the company that can be derived by using the WACC or other methods. The final value of the financial instrument can be calculated by using the following formula that is known Gordon Growth Model.
Final Value = estimated cash flow for the last year (1 + long term growth rate) / (discount rate – long-term growth rate)
Next you have to calculate the cash flow for each of the period that includes the end value. Finally you add all the periods together while making adjustment for present values. In real world situation, financial software are used to calculate DCF value.
The advantage of DCF method to evaluate investment opportunities is that it is relatively easy to perform. Moreover, the result is more accurate as compared to estimating the value using metrics such as EV/EBITDA, price-earnings (P/E), and price-to-sales ratio.
However, a drawback of the model is that the results are only as good as the assumptions. If the inputs such as the discount rates, free cash flow forecasts, and growth rate are inaccurate, the predictions using this method will be flawed as well.
Further Reading
- Free Cash Flow (FCF), Economic Value Added (EVA™), and Net Present Value (NPV):. A Reconciliation of Variations of Discounted-Cash-Flow (DCF) Valuation – www.tandfonline.com [PDF]
- Discounted cash flow in historical perspective – www.jstor.org [PDF]
- Firm valuation: comparing the residual income and discounted cash flow approaches – www.sciencedirect.com [PDF]
- A discounted cash flow approach to property-liability insurance rate regulation – link.springer.com [PDF]
- The accuracy of Price‐Earnings and discounted cash flow methods of IPO equity valuation – onlinelibrary.wiley.com [PDF]
- Multi-period discounted cash flow rate-making models in property-liability insurance – www.jstor.org [PDF]
- Valuing companies by cash flow discounting: ten methods and nine theories – www.emerald.com [PDF]
- Inventory and credit decisions for time-varying deteriorating items with up-stream and down-stream trade credit financing by discounted cash flow analysis – www.sciencedirect.com [PDF]
