What is Discounted Cash Flow and How is It Calculated?
One of the most well-known financial metrics is the discounted cash flow which measures the future prospects or growth outlook of a company based on its current cash flows. Investors can also get an idea of whether the company or the asset is overvalued or undervalued.
Read on to understand what discounted cash flow is and its importance, formula, calculation, example, benefits and limitations.
What is Discounted Cash Flow?
It is a financial metric used by stakeholders and investors to measure expected returns in the future from an asset. DCF valuation methods consider several factors, like current cash flows, among others, to get the result. In other words, discounted cash flow or DCF analysis the future cash flows of the asset.
It functions on the concept of the time value of money. It states that the current value of money is different from its future value, and there should be a discounting factor for correctly analysing the future value of money.
How Does Discounted Cash Flow Work?
The main purpose of DCF is to provide an estimation of future returns generated from an investment by taking into account the time value of money. It is immensely beneficial for investors as they are investing today, hoping for returns from the same in future.
Let’s consider an example to see how DCF works. Suppose you have Rs.1,000 with you, which you can invest to earn returns or interest at the rate of 8% per annum. If you go ahead with the investment, the future worth of your investment will be Rs.1,080. However, if you do not invest the same, the value of your money after one year will be Rs.920 because you didn’t transfer it to your savings account to earn interest.
The DCF analysis allows us to get an idea of future earnings from an investment based on the current cash flows. Moreover, you can also get to know whether the future returns will be higher or lower from an initial investment.
You must determine a discount rate for efficient calculation of DCF value. The discount rate for the corresponding DCF model will vary for one project over another. The company’s risk profile and prevailing conditions in respective capital markets play a huge role in determining the discount rate accurately.
Why is DCF Important?
The DCF valuation is important for various stakeholders of a company or asset. It helps them understand whether an investment is overvalued or undervalued. Moreover, if the calculated DCF value is higher than the original cost of investment, in these cases, you can go ahead with the investment.
On the other hand, if the DCF value is lower than the current investment amount, you may have to undertake further research based on other metrics or tools to decide whether the investment is worthy or not. It considers important factors pertaining to a firm, like its future growth, profits, and discount rates. Using these factors along with DCF analysis gives individuals a reality check on prospective assets.
What is the Formula to Calculate Discounted Cash Flow?
Here is the basic DCF formula that you can use:
Discounted Cash Flow or DCF = CF1/ (1+r)1 + CF2/(1+r)2+ CFn/ (1+r)n
Whereby CF1 implies cash flows generated from first year;
Cf2 implies cash flows in the second year, and CFn exhibits cash flows from additional years;
R implies the discount rate by considering the risky nature of an asset.
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How to Calculate Discounted Cash Flow by Using the WACC method?
Let’s understand the various components of discounted cash flow formula:
Discounted Cash Flow = CF1 / (1+dr) 1 + CF2/ (1+dr) 2 +….. + CFn/ (1+dr) n
Here, DCF is a summation of future discounted cash flows generated from the investment.
CF is cash flows generated for a specific year, and dr is the weighted average cost of capital or discount rate.
• Weighted Average Cost of Capital (WACC)
Now that we are aware of the DCF formula, it is the right time to shift our focus towards discount or weighted average cost of capital. It is the average post tax cost of capital for a company. This includes capital acquired from various sources like equity shares, preference shares, bonds, etc.
In other words, the weighted average cost of capital is the average expense rate that a company may incur for shoring up its finances. It is also used in computing the expected rate of return. It will be equivalent to what bondholders and shareholders may ask companies for providing capital.
Companies having volatile share value or debts from risky sources will have a higher WACC. This is because creditors or investors would demand a premium or higher return for investing their money in such risky ventures.
Example of Discounted Cash Flow Analysis
Let’s understand the calculation of DCF with an example:
A company is planning to start a project which entails an initial investment amounting to Rs. 8 lakh. The discount rate is 5%, and the life span of the said project is 4 years. Here are some expected cash flows from the following project:
| Cash flow (Rs) | Year |
| 2 Lakh | 1 |
| 3 lakh | 2 |
| 3 lakh | 3 |
| 4 Lakh | 4 |
Now, let’s see discounted cash flows that the company or asset might generate:
| Year | Cash flows (Rs) | Discounted cash flows (Rs) |
| 1 | 2 lakh | 1,90,500 |
| 2 | 3 lakh | 2,86,600 |
| 3 | 3 lakh | 2, 72, 000 |
| 4 | 4 lakh | 3,81, 400 |
The total cash flows using DCF is Rs.11,30,500; the initial cost of investment is 8 lakh. It means that the net present value, which is the difference between DCF and initial investment, is positive amounting to Rs.3,30,500.
Such a scenario introduces the opportunity of gaining expected revenues in the future, which would be more than the investment cost; thereby, it might be beneficial for the investors.
What is Terminal Value in DCF?
The terminal value is also an important aspect of the DCF formula. It implies the growth rate of cash flows apart from the period considered. You can compute a terminal value using the following methods:
1. Perpetuity method
This method uses a particular formula for calculating the terminal value, which is as follows:
[FCFnx(1+g)]/(WACC-g);
Here, FCF implies the free cash flow that a company may generate, and g is the growth rate of FCF.
2. Exit multiple methods
Under this method, trading multiple gets multiplied by any financial metric such as EBITDA. For example, one can get the terminal value by multiplying EBITDA by 10.
Benefits of Using DCF Method
Here are some benefits of doing a DCF analysis:
- Companies can analyse the efficacy of mergers and acquisitions using DCF.
- One can also get to know the intrinsic or actual value of the company.
- Another advantage associated with DCF is that it is applicable to diverse projects or companies.
- It is an easy and convenient way of computing expected return after considering the various assumptions.
Disadvantages of Using DCF Methods
Some cons of DCF are as follows:
- The method might be time consuming because there are several factors and variables involved.
- DCF may not be a reliable estimate when future cash flows cannot be estimated.
- Projections may not always be accurate due to the volatility of assets or the cyclicity of companies.
How is DCF Used?
This financial metric is hugely popular among investors in determining their expected cash flows in future from their investments. It is ideal for large companies to have a relatively stable growth outlook than their smaller counterparts.
Oil, telecom, infrastructure, power, etc., are some of the companies having valuations in terms of billions of dollars; they regularly discount the expected cash flows for any project undertaken by them. Individuals can use the various DCF valuation methods before going ahead with an investment.
How Does DCF Affect Investors?
Investors take a keen interest in discounted cash flows because it gives them an idea regarding the returns that can get generated in the future. If DCF value is higher than the initial investment amount, it may be an attractive or lucrative investment option. This is because investments tend to be undervalued and may generate significant returns in future.
On the other hand, if DCF is less than the investment amount, it indicates overvaluation of the asset or company. Therefore, putting in your money during such a scenario might not be a good option, considering bleak or meagre return prospects.
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Final Word
Discounted cash flow is an important tool which uses several parameters to determine expected cash flows from an investment in the long term. As the name suggests, it discounts cash flows and helps investors make a decision regarding investment. It is considered to be one of the best cash flow methods because it helps experts arrive at a fair market value during valuations.
FAQs
Ans: No, both concepts are not the same, although closely interrelated. You can compute NPV after deducting DCF from the original cost of investment. Therefore, both of them are different concepts, but the existence of one is closely related to the other.
Ans: If you use DCF methods to value a company, you will get to determine the company’s equity value. However, you can calculate the enterprise value from the equity value by using this formula: Enterprise value = (Equity value – free cash flow) + Total debt.
Ans: EBITDA is used to measure the cash flow of a company. In case you are using a valuation multiple like EBITDA for the terminal value, it must reflect the business situation during the end of the forecast period and not on the valuation date.
Ans: Some of the primary DCF methods that financial analysts and accountants use are the net present value (NPV) method, the Cash Flow to Equity method and the WACC method. The WACC method calculates the DCF by dividing the sum of the cash flow during each period by the discount rate plus one.
Ans: Some of the common variations of DCF valuation models include the dividend discount model (DDM) and the free cash flow model (FCF). The FCF model can be further categorised into the free cash flow to equity model (FCFE) and the free cash flow to firm model (FCFF).
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
