To those in the financial markets, though, pricing out a company, an investment, or any type of income-producing asset in general is more science than art. 4. Discounted Cash Flow: One of the strongest, most reliable, and theoretically soundest models among all approaches to estimate value. The DCF formula has made investor, analyst, entrepreneur alike more informed about understanding the business financial aspect better.
This guide will decompose the DCF model, showing how it works along with real-life examples and how to use a DCF calculator to save time.
What is Discounted Cash Flow?
Simply put, Discounted Cash Flow is a valuation technique used to ascertain the value of an investment based on its predicted future cash flows. The basic concept is that contrary to popular beliefs, money loses value over time because of risk, inflation, and opportunity cost. As a result, cash you expect to get in the future is worth less than cash you have as of today.
This allows you to estimate its present value based on the cash flows it is projected to generate in the future, by applying the DCF formula. It is a commonly employed tool in equity research, business valuations and investment banking.
What is the DCF Formula? A Breakdown
The standard DCF formula is:
DCF=CFn1+rn
Where:
- CF = expected future cash flows for each period
- r = discount rate or required return
- n = number of periods
This formula gives you the current value of expected future cash flows. The cash flow further in the future is discounted heavier.
Elements of the DCF Formula
To correctly implement the DCF formula, you need a clear understanding of the individual components:
Future Cash Flows
This is exactly the projection of earnings that the business or investment will generate over time. Depending on the context, these cash flows can refer to operating cash flows, net income or free cash flows.
Discount Rate
The discount rate accounts for the time value of money and the risk of the cash flows. The required rate of return or the weighted average cost of capital (WACC) of the company.
Terminal Value
In many instances, companies are expected to survive forever.” An additional terminal value is calculated at the end of the forecast period (usually covering a 5–10 year range) to capture value beyond the explicit estimate, using either the perpetuity growth method or the exit multiple method.
Why Use the DCF Model?
The DCF model also offers a more fundamental approach to price discovery as opposed to a more market-based approach. It enables analysts to place their valuation on expected performance instead of comparable entities or market prices.
Benefits of the DCF Model:
- Based on the real financial performance
- Risk-neutral through discount rate adjustment
- This applies to a broad section of investing decisions
- Valuate startups, real estate, capex projects.
Nevertheless, the DCF model is only as good as the assumptions it is based on. If cash flows are poorly projected or discount rates too unrealistic, the valuation can be misleading.
Discounted Cash Flow Calculation Example
Let us take an example to see how the DCF formula works.
Let’s say that you are looking at a small business that you expect to generate the following free cash flows for the next 5 years:
Year 1: $100,000
Year 2: $110,000
Year 3: $120,000
Year 4: $130,000
Year 5: $140,000
For these calculations, assume a discount rate of 10%.
Step-by-step DCF Calculation:
They’re all at 10 years, you back out through methods of DCF:
DCF=100,0001+0.101+110,0001+0.102+120,0001+0.103+130,0001+0.104+140,0001+0.105
Calculating each term:
Year 1: $90,909
Year 2: $90,909
Year 3: $90,163
Year 4: $88,697
Year 5: $86,820
Adding them up:
DCF = $447,498
This amount is the present value of the forecasted cash flows. Values below $447,498 imply the business investment is less costly.
Terminal Value in DCF Analysis
Most discounted cash flow (DCF) models — as noted previously — include a terminal value to capture cash flows beyond the forecast period. A common method is the Gordon Growth Model, which you calculate as follows:
TV= CFn1+gr-g
Where:
- CFn is the latest forecasted cash flow
- g is the annual growth rate
- r is the discount rate
When calculating terminal value, it is discounted to present value and added to the sum of discounted cash flow.
Read More: Discounted Cash Flow Analysis
Using a DCF Calculator
For complicated projects or businesses with many streams of cash flows, manually applying the DCF formula can take time. That is where a DCF calculator comes in handy.
A DCF calculator does this work automatically by allowing users to enter:
- Forecasted cash flows
- Discount rate
- Terminal growth rate
- Number of years
And it outputs:
- Net present value (NPV)
- Terminal value
- Total enterprise value
Many financial platforms are online and allow DCF calculations, such as Excel and Google Sheets, either built in, or using online templates, allowing for simple calculations with minimal human error.
The DCF Valuation Process and Common Mistakes to Avoid
While the DCF model has its advantages, it does have its drawbacks. Here are some issues that need to be careful about while being an analyst:
Overly Optimistic Forecasts
A reasonable projection assumes exponential growth or unrealistically-profitable margins that could inflate valuation results. Setting projections based on historical performance and market conditions is grounded in logic.
Incorrect Discount Rate
There can be large variations due to the use of an incorrect rate. In other words, the discount rate should reflect the riskiness of the cash flows and the cost of capital.
Ignoring Sensitivity Analysis
The DCF model is very sensitive to inputs. Without scenario and sensitivity analyses, an incomplete picture of risks and returns emerges.
Enhancing DCF Accuracy
Here are a few best practices to make sure that your discounted cash flow analysis is as accurate as possible:
- Be conservative in your growth rates
- Benchmark industry data to validate assumptions
- Update forecasts periodically
- Consider macroeconomic factors (inflation, interest rates)
- Create multiple scenarios to model uncertainty
And this is the great thing about these principles — they make the DCF formula’s output can thus be relatively more grounded and actionable in terms of valuation.
Read More: 3-Statement Financial Model
DCF vs. Other Valuation Methods
The DCF model is a popular method, though by no means the only method. Other methods include:
- Comparable Company Analysis (Comparable)
- Precedent Transactions
- Asset-based Valuation
- Dividends Discounting Models (DDM)
The appropriate method can depend on the aim of the valuation, as well as data availability. Nonetheless, the DCF formula is the preferred technique most of the time when cash flows are foreseeable and long-term performance is the heart of the valuation process.
Discounted Cash Flow Analysis Use Cases
The discounted cash flow (DCF) model is applied by various industries and professionals:
- M&A deal investment bankers
- Data for startup valuation: Venture capitalists
- Property assessors for real estate investors
- Capital budgeting in corporate finance teams
- Equity Research Analysts for target price predictions
Discounted cash flow analysis is a fundamental of modern financial valuation because of its versatility and precision.
Final Thoughts
By getting this formula, it gives you a great tool for analyzing intrinsic value of any cash generating asset. It sounds complicated on first blush but the logic is simple: money today is worth more than money tomorrow, and good investment choices must take that fact into account.
When used properly, the DCF model can help to cut through the noise of the market and allow you to focus on the determinants of value—cash flow, risk and growth. Overall, a DCF calculator simplifies the process of calculating the weighted average of cash flows over time so that you can quickly adjust different variables to see how it impacts the financial forecasts and make sure you’re making informed decisions.
In a world with market speculation, hype and noise, the discounted cash flow approach provides a healthy dose of financial logic and discipline.
