What Is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) refers to a valuation method that estimates the value of an investment using its expected future cash flows.
DCF analysis attempts to determine the value of an investmenttoday, based on projections of how much money that investment will generate in thefuture.
It can help those considering whether to acquire a company or buy securities. Discounted cash flow analysis can also assist business owners and managers in making capital budgeting or operating expenditures decisions.
Key Takeaways
- Discounted cash flow analysis helps to determine the value of an investment based on its future cash flows.
- The present value of expected future cash flows is arrived at by using a projected discount rate.
- If the DCF is higher than the current cost of the investment, the opportunity could result in positive returns and may be worthwhile.
- Companies typically use the weighted average cost of capital (WACC) for the discount rate because it accounts for the rate of return expected by shareholders.
- A disadvantage of DCF is its reliance on estimations of future cash flows, which could prove inaccurate.
:max_bytes(150000):strip_icc()/DCF-f7593de5b9444e378b90a237a9bd83f6.png "Discounted Cash Flow (DCF) Explained With Formula and Examples (1)")
How Does Discounted Cash Flow (DCF) Work?
The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money.
The time value of money assumes that a dollar that you have today is worth more than a dollar that you receive tomorrow because it can be invested. As such, a DCF analysis is useful in any situation where a person is paying money in the present with expectations of receiving more money in the future.
For example, assuming a 5% annual interest rate, $1 in a savings account will be worth $1.05 in a year. Similarly, if a $1 payment is delayed for a year, its present value is 95 cents because you cannot transfer it to your savings account to earn interest.
Discounted cash flow analysis finds the present value of expected future cash flows using a discount rate. Investors can use the concept of the present value of money to determine whether the future cash flows of an investment or project are greater than the value of the initial investment.
If the DCF value calculated is higher than the current cost of the investment, the opportunity should be considered. If the calculated value is lower than the cost, then it may not be a good opportunity, or more research and analysis may be needed before moving forward with it.
To conduct a DCF analysis, an investor must make estimates about future cash flows and the ending value of the investment, equipment, or other assets.
The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration. Factors such as the company or investor's risk profile and the conditions of the capital markets can affect the discount rate chosen.
If the investor cannot estimate future cash flows or the project is very complex, DCF will not have much value and alternative models should be employed.
For DCF analysis to be of value, estimates used in the calculation must be as solid as possible. Badly estimated future cash flows that are too high can result in an investment that might not pay off enough in the future. Likewise, if future cash flows are too low due to rough estimates, they can make an investment appear too costly, which could result in missed opportunities.
Discounted Cash Flow Formula
The formula for DCF is:
DCF=(1+r)1CF1+(1+r)2CF2+(1+r)nCFnwhere:CF1=ThecashflowforyearoneCF2=ThecashflowforyeartwoCFn=Thecashflowforadditionalyearsr=Thediscountrate
Example of DCF
When a company analyzes whether it should invest in a certain project or purchase new equipment, it usually uses its weighted average cost of capital (WACC) as the discount rate to evaluate the DCF.
The WACC incorporates the average rate of return that shareholders in the firm are expecting for the given year.
For example, say that your company wants to launch a project. The company's WACC is 5%. That means that you will use 5% as your discount rate.
The initial investment is $11 million, and the project will last for five years, with the following estimated cash flows per year.
| Cash Flow | |
|---|---|
| Year | Cash Flow |
| 1 | $1 million |
| 2 | $1 million |
| 3 | $4 million |
| 4 | $4 million |
| 5 | $6 million |
Using the DCF formula, the calculated discounted cash flows for the project are as follows.
| Discounted Cash Flow | ||
|---|---|---|
| Year | Cash Flow | Discounted Cash Flow (nearest $) |
| 1 | $1 million | $952,381 |
| 2 | $1 million | $907,029 |
| 3 | $4 million | $3,455,350 |
| 4 | $4 million | $3,290,810 |
| 5 | $6 million | $4,701,157 |
Adding up all of the discounted cash flows results in a value of $13,306,727. By subtracting the initial investment of $11 million from that value, we get a net present value (NPV) of $2,306,727.
The positive number of $2,306,727 indicates that the project could generate a return higher than the initial cost—a positive return on the investment. Therefore, the project may be worth making.
If the project had cost $14 million, the NPV would have been -$693,272. That would indicate that the project cost would be more than the projected return. Thus, it might not be worth making.
Dividend discount models, such as the Gordon Growth Model (GGM) for valuing stocks, are other analysis examples that use discounted cash flows.
Advantages and Disadvantages of DCF
Advantages
Discounted cash flow analysis can provide investors and companies with an idea of whether a proposed investment is worthwhile.
It is an analysis that can be applied to a variety of investments and capital projects where future cash flows can be reasonably estimated.
Its projections can be tweaked to provide different results for various what-if scenarios. This can help users account for different projections that might be possible.
Disadvantages
The major limitation of discounted cash flow analysis is that it involves estimates, not actual figures. So the result of DCF is also an estimate. That means that for DCF to be useful, individual investors and companies must estimate a discount rate and cash flows correctly.
Furthermore, future cash flows rely on a variety of factors, such as marketdemand, the status of the economy, technology, competition, and unforeseen threats or opportunities. These can't be quantified exactly. Investors must understand this inherent drawback for their decision-making.
DCF shouldn't necessarily be relied on exclusively even if solid estimates can be made. Companies and investors should consider other, known factors as well when sizing up an investment opportunity. In addition, comparable company analysis and precedent transactions are two other, common valuation methods that might be used.
How Do You Calculate DCF?
Calculating the DCF involves three basic steps. One, forecast the expected cash flows from the investment. Two, select a discount rate, typically based on the cost of financing the investment or the opportunity cost presented by alternative investments. Three, discount the forecasted cash flows back to the present day, using a financial calculator, a spreadsheet, or a manual calculation.
What Is an Example of a DCF Calculation?
You have a discount rate of 10% and an investment opportunity that would produce $100 per year for the following three years. Your goal is to calculate the value today—the present value—of this stream of future cash flows.
Since money in the future is worth less than money today, you reduce the present value of each of these cash flows by your 10% discount rate. Specifically, the first year’s cash flow is worth $90.91 today, the second year’s cash flow is worth $82.64 today, and the third year’s cash flow is worth $75.13 today. Adding up these three cash flows, you conclude that the DCF of the investment is $248.68.
Is Discounted Cash Flow the Same As Net Present Value (NPV)?
No, it's not, although the two concepts are closely related. NPV adds a fourth step to the DCF calculation process. After forecasting the expected cash flows, selecting a discount rate, discounting those cash flows, and totaling them, NPV then deducts the upfront cost of the investment from the DCF. For instance, if the cost of purchasing the investment in our above example were $200, then the NPV of that investment would be $248.68 minus $200, or $48.68.
The Bottom Line
Discounted cash flow is a valuation method that estimates the value of an investment based on its expected future cash flows. By using a DFC calculation, investors can estimate the profit they could make with an investment (adjusted for the time value of money). The value of expected future cash flows is first calculated by using a projected discount rate. If the discounted cash flow is higher than the current cost of the investment, the investment opportunity could be worthwhile.
