Most finance courses espouse the gospel of discounted cash flow (DCF) analysis as the preferred valuation methodology for all cash flow-generating assets. In theory (and in college final examinations), this technique works great. In practice, however, DCF can be difficult to apply in evaluating equities.
Even if one believes the gospel of DCF, other approaches are useful to help generate a complete valuation picture of a stock.
Discounted Cash Flow | DCF Model Step by Step Guide
Discounted cash flow formula
The discounted cash flow formula works by adding all the cash flows for each reporting period and dividing these sums by one plus the discount rate raised to the n power.
DCF = [(cash flow) ÷ (1 + r)^1] + [(cash flow) ÷ (1 + r)^2] + [(cash flow) + (1 + r)^n]
The components of the formula break down as:
What is discounted cash flow?
A companys discounted cash flow—”DCF” for short—is a method finance professionals use to determine the approximate value of a certain investment based on the future cash flow the company expects to generate. Analyzing discounted cash flow helps companies determine what the current value of an investment is when it evaluates its financial projections of how much it should earn in the future. The DCF is an important metric for both investment professionals and business professionals who oversee or otherwise decide on changes to business processes, such as hiring new staff or purchasing new equipment.
Advantages and disadvantages of discounted cash flow
The discounted cash flow formula can have both advantages and drawbacks, depending on what financial experts use it for. For instance, measuring the future worth of a stock purchase is a situation where the discounted cash flow analysis is helpful, whereas the formula is unlikely to have any benefit for analyzing operating expenses on a companys balance sheet. Consider several more benefits and drawbacks of the discounted cash flow method:
When companies need to estimate whether an investments future return is worth the cost, such as in the case of purchasing long-term assets or acquiring new businesses, the discounted cash flow method can be highly advantageous for:
In other circumstances, the discounted cash flow formula can have drawbacks, including:
How does discounted cash flow work?
Essentially, investment and finance experts rely on the DCF to help them determine whether paying to invest in something is worth what the future returns can offer. To calculate discounted cash flow, you can perform a DCF analysis:
Discounted cash flow analysis
A DCF analysis is an effective tool that investors and businesses can use to estimate the future value of an investment opportunity according to the time value of money. The concept of the time value of money is that the future value of any money you invest should be worth more than its current value.
A DCF analysis gives you the current value of a companys expected cash flows in the future, providing insight into whether future investment returns are worth the cost. If the projected future cash flow is greater than or equal to the current value of the investment, a company may decide to go ahead with investing or otherwise taking on a project meant to generate higher earnings in the future.
Estimating the future value of an investment
When conducting a DCF analysis, investors and businesses must make estimations for future cash flows and the future value of the investment. For instance, a company considering a new business acquisition must estimate the future cash flows from expanding its processes and operations with the acquisition. The estimates the company makes can help determine if the investment is worth the cost of the acquisition.
Other assets a company considers when estimating future investment returns and cash flows include equipment, property or land, office buildings, resources, inventory and financial assets like stocks and bonds. Additionally, companies take depreciation into account when estimating future earnings. For example, manufacturing companies that purchase new production equipment typically subtract the depreciation value from the future value at the end of the equipments lifetime.
Determining discount rate
The discount rate is one of the most important elements of the DCF formula. Businesses need to identify an appropriate value for the discount rate if they are unable to rely on a weighted average cost of capital. Additionally, the discount rate can vary depending on a range of factors like an organizations risk profile and the current conditions of capital markets. If you are unable to determine a discount rate or rely on a WACC value, an alternative model may be more beneficial and accurate.
Applying the DCF formula
When investment and finance professionals perform a DCF analysis, determine the discount rate and have estimates for future cash flows, they can apply these values in the DCF formula to create a future outline that details expected returns. If the results appear at or above a companys initial projections for future cash flows, then investing can be beneficial. However, if the discounted cash flow formula results in a value below a companys projected future returns, it may consider alternative investments.
As an example, assume a company has the following information from its DCF analysis:
If the company is measuring the discounted cash flow over three years, it uses the formula and substitutes for n = 3, r = 0.15 and cash flow is equal to $450,000:
DCF = [(cash flow) ÷ (1 + r)^1] + [(cash flow) ÷ (1 + r)^2] + [(cash flow) + (1 + r)^n] =
[($450,000) ÷ (1 + 0.15)^1] + [($450,000) ÷ (1 + 0.15)^2] + [($450,000) + (1 + 0.15)^3] =
($391,304) + ($340,265) + ($295,882) = $1,027,451
The discounted cash flow shows that the company can expect the investment to provide them a return that appears well above its initial projection of $925,000. Because of the high valuation of the future expected cash flow, the company may decide to go ahead with its investment.