Discounted Cash Flow: What Is It and How It Works
Discounted cash flow is a valuation method used to estimate the value of a company based on its future cash flows. In simple terms, the DCF analysis calculates how much money a business will generate in the future and discounts it back to the present day. This number is then compared to the company’s current market value to see if it’s under or overvalued.
DCF analyses are commonly used in business valuation, capital budgeting, and investment analysis.
There are a few different ways to calculate it, but all versions use some variation of future cash flows, risk, and time value of money. Let’s look at how the DCF method works and how you can use it to value a business.
The DCF Formula
The discounted cash flow formula is used to determine the value of a company by discounting all of its future cash flows.
The DCF formula is:
DCF =CF1/(1+r)^1+ CF2/(1+r)^2+...+CFn/(1+r)^n
CF = cash flow
r = discount rate
n = the number of periods
Before doing the calculation, it’s important to understand all three components in the discounted future cash flow formula. They are:
- The cash flows (CF): These are the net cash payments from the investment. Investors who own trading security will receive these payments over a specific amount of time.
- The discount rate (r): For business valuation purposes, it’s the interest rate you need to earn on the amount of money you own today to end up with a certain amount of money in the future. It helps determine whether the investment is sound. Companies often use WACC as their discount rate when calculating DCF.
- The number of periods (n): The number of periods over which the cash flows will occur. It can be years, months, quarters, or any other period.
How To Use the DCF Formula
There are a few things to keep in mind when using the DCF formula:
- Calculate your future cash flows accurately: This is the most important part of using the DCF formula. If you don't do it properly, then your DCF valuation won’t be inaccurate.
- Use a reasonable discount rate: The discount rate you use should reflect the risk of the investment. The higher the risk, the higher the discount rate.
- Consider the time value of money: The DCF formula takes into account the time value of money, which means that future discounted cash flows are worth less than present cash flows.
- Focus on the long term: The DCF formula is most useful when valuing long-term investments. This is because it can be difficult to estimate cash flows accurately over a short period of time.
- Use caution when extrapolating past results: The DCF formula should not be used on past results. The future is often different from the past, and cash flows can be very volatile.
Discounted Cash Flow Analysis Example
Let's take a look at an example to better understand how the DCF formula works in practice.
Suppose you are considering investing in a new company. The company is expected to generate the following cash flows over the next five years:
Year 1: $100,000
Year 2: $150,000
Year 3: $200,000
Year 4: $250,000
Year 5: $300,000
The discount rate is 10%.
To calculate the present value of these cash flows using the DCF formula, we need to discount each cash flow by 10% for each year.
This gives us the following today's value of cash flows:
Year 1: $100,000/(1+10%)^1 = $100,000/1.1 = $90,909
Year 2: $150,000/(1+10%)^2 = $150,000/1.21 = $124,675
Year 3: $200,000/(1+10%)^3 = $200,000/1.331 = $150,226
Year 4: $250,000/(1+10%)^4 = $250,000/1.464 = $172,413
Year 5: $300,000/(1+10%)^5 = $300,000/1.611 = $186,174
The present value of all these cash flows is the sum of the present value of each individual cash flow. This gives us a total value of $724,397, meaning that if we were to invest that sum today, we would expect cash flows of $100,000 in Year 1, $150,000 in Year 2, and so on.
What Is the DCF Formula Used For?
The DCF valuation formula can be used for a variety of purposes, including:
- Valuing the Entire Business
Business valuation can be requested for a number of reasons, such as the sale of the company, taxation or establishing partner ownership.
- Evaluating an Investment in the Company
The DCF formula can be used to evaluate whether an investment is likely to be profitable or not. If the present value is positive, then the investment is likely to be profitable.
- Making Decisions About Capital Budgeting
The DCF valuation can be used to help make decisions about which projects to invest in and which to avoid. For example, if you’re planning to start a real estate LLC, this can help you decide where to invest.
- Valuing a Bond
Bonds can be valued using the DCF formula by discounting their future interest payments at the required rate of return. This is known as the yield to maturity.
- Managing Risk
The DCF formula can be used to help manage risk by estimating the present value of cash flows that are expected to be generated in the future. This is important for both investors and businesses because it allows them to assess the potential risk of an investment.
DCF has several limitations that make it less accurate than other valuation methods.
One limitation of the DCF model is that it relies heavily on estimates and assumptions. For example, in order to discount future cash flows, you must estimate the appropriate discount rate. This discount rate is a key input into the model, and small changes in this rate can have a big impact on the overall value of the investment.
Another limitation of DCF is that it only considers the cash flows that are expected to be generated by the investment. It does not take into account other factors that may affect the value of the investment, such as expected growth or risk.
Finally, DCF analysis can be difficult to use in practice because it requires a lot of data and can be time-consuming to set up. For these reasons, DCF analysis is not always the best valuation method.
Discounted Cash Flow vs. Net Present Value
It's important to note that the DCF formula is very similar to the net present value (NPV) formula. The main difference between the two is that the DCF formula uses expected future cash flows, while the NPV formula uses actual cash flows.
Both formulas are used to estimate the present value of future cash flows. However, the DCF analysis is more commonly used because it is easier to estimate expected future cash flows than it is to estimate actual cash flows.
The discounted cash flow method is a great way to value companies, but it’s not perfect. There are a number of drawbacks that you should keep in mind when using this method.
First, the discount rate is a critical assumption. If you use too high of a discount rate, you will undervalue the company. Second, the cash flows used in the analysis are estimates, and they may be wrong. Finally, the discount rate used in the analysis is a forward-looking rate, so it may not reflect reality.
Despite these drawbacks, the DCF method is still a powerful tool for valuing companies.
The DCF is calculated by discounting the investment’s expected cash flows to today’s value at a discount rate that reflects the riskiness of the investment.
No, NPV and DCF are not the same. The net present value is the current value of an investment, while discounted cash flow is a method used to calculate the current value.
The three discounted cash flow techniques are the net present value method, the internal rate of return method, and the discounted payback period method.
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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