It goes without saying that each business investment should be approached carefully and strategically. One way to estimate whether an investment is risky is to employ a discounted cash flow (DCF) analysis. Keep on reading to learn more about this valuation method, including how to calculate it and its advantages and disadvantages.
The term discounted cash flow (DCF) is used for a valuation of an investment based on its expected future cash flows. In other words, this method estimates how much capital a business will generate in the future while taking into account the time value of money. Therefore, DCF lets you see how much the expected cash flows would be worth at present.
The term discounted cash flow is sometimes used interchangeably with net present value (NPV). Although they are quite similar, a distinction can be made between the two. To be precise, NPV adds another step to the DCF calculation. After DCF is calculated, the upfront investment costs are subtracted to get the NPV value.
To calculate the discounted cash flow, you should use a discounted cash flow formula. The most commonly used one is as follows:
DCF = CF1/(1+r)^1+ CF2/(1+r)^2+...+CFn/(1+r)^n
CF1 stands for the cash flow for the first time period, CF2 marks the second, while CFn is there to denote each following period. The discount rate is r. Let’s explain these three elements in more detail.
There are several cash flow types, such as operating cash flow and unlevered free cash flow. In this case, unlevered free cash flow is used. It refers to net cash payments acquired by the investor for the securities they have, such as bonds and shares.
The number of periods simply refers to the number of years, months, or quarters you are calculating the discounted cash flow for. The periods are typically equal, but if they’re not, they are presented as a percentage of a given year.
In most cases, when evaluating a business, the discount rate is simply the company’s Weighted Average Cost of Capital (WACC). WACC measures the cost to a business to borrow money and is calculated by considering the company’s debt and equity financing.
The formula for calculating the WACC is the following:
WACC = (E/V x Re) + ((D/V x Rd) x (1 – T))
E represents the market value of the firm’s equity, while D is the market value of the firm’s debt. V stands for the total value of capital, which is the sum of equity and debt. Furthermore, E/V denotes the percentage of capital that is equity, and D/V is the percentage that is debt. Finally, Re is the cost of equity, Rd stands for the cost of debt, and T is the tax rate.
To make things simpler, we’ll show you a DCF example. Let’s say you plan on investing in a company that is projected to have the following cash flow over the next five years:
The discount rate we’ll use in this example is 10%. Here is what the calculation looks like when the formula is applied.
Year 1: $500,000/(1+10%)^1 = $500,000/1.1 = $454,545
Year 2: $550,000/(1+10%)^2 = $550,000/1.21 = $454,545
Year 3: $600,000/(1+10%)^3 = $600,000/1.331 = $450,788
Year 4: $750,000/(1+10%)^4 = $750,000/1.464 = $512,295
Year 5: $900,000/(1+10%)^5 = $900,000/1.611 = $558,659
When we add up the calculated discounted cash flows for all of the years, we get a total of $2,430,832. That number represents the discounted cash flow for this five-year period.
The main perk of the discounted cash flow method is that it allows businesses and other investors to make predictions about potential investment opportunities. It’s also adjustable, so you may get different results in different scenarios.
On the other hand, this valuation method has some major limitations, making it less reliable than other options. Namely, it relies heavily on estimations. One of the elements in the DCF formula is the discount rate, and any mistakes here will lead to highly inaccurate results.
Using the discounted cash flow formula can be useful for estimating whether an investment is worthwhile. However, it should be applied with caution, given that the formula’s key elements are approximations, so the result may not be as precise as you need it to be.
DCF is called that way because it uses the projected cash flow in its calculations. It’s “discounted” because it takes into account the time value of money. According to that financial principle, an amount of money is worth more now than it will be in the future.
Discounted cash flow analysis can be quite helpful if you approach it carefully and keep in mind that it may not be completely accurate. It should be used when you plan on investing a sum of money with expectations to receive a larger future payout.
Its most prominent weakness is that it relies heavily on assumptions, as elements of the formula, like the WACC, are estimated values. Furthermore, it’s limited to company valuation in isolation, without looking at the broader picture.
Discounted cash flow is not suitable for evaluating the potential of a short-term investment.
Danica’s greatest passion is writing. From small businesses, tech, and digital marketing, to academic folklore analysis, movie reviews, and anthropology — she’s done it all. A literature major with a passion for business, software, and fun new gadgets, she has turned her writing craft into a profitable blogging business. When she’s not writing for SmallBizGenius, Danica enjoys hiking, trying to perfect her burger-making skills, and dreaming about vacations in Greece.
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