Discounted Cash Flow (DCF) is one of the most essential valuation methods we have in finance and investing. A business owner who wants to discover the value of your company or an investor who wants to make better investment decisions, knowing discounted cash flow is a must. It is considered to be an accurate way to estimate the value of a business, project, or investment based on the cash flows it is expected to generate in the future.
What is discounted cash flow, why is it important, and how to calculate discounted cash flow (with a real-life example). In this blog, we will dissect these three questions. These skills will give you the tools to make better investment analysis and help you make data-driven decisions in finance and business strategy.
What Is Discounted Cash Flow?
Discounted cash flow, or DCF for short, is a valuation method for estimating the value of an investment based on its expected future cash flows. These cash flows are discounted (or adjusted) for the time value of money — meaning that a dollar today is worth more than a dollar tomorrow because of the potential earning capacity of money.
A common DCF calculation will estimate the future cash that a business or asset will generate and then discount those future cash flows to the present value using a present value formula. It provides an intrinsic value estimate of that investment that will be the final output.
An investment is attractive if its cash flow valuation determines a value higher than the current cost.
What Is Discounted Cash Flow And Why Is It Important?
Despite its shortcomings, DCF is still widely used in investment analysis for a number of good reasons:
- Required Rate of Return: DCF takes time value of money into account as future cash flows must be discounted to arrive at their present value.
- Intrinsic Valuation: Whereas relative valuation methods compare an asset to other assets to determine its value, DCF measures the fundamental health of a business, or an asset.
- Strategic Planning: It helps organisations evaluate the viability of projects, acquisitions or growth strategies.
- Investors Insights: Investors use DCF to figure out if a stock or asset is overvalued or undervalued — inverse of discounted free cash flow.
Read More: Discounted Cash Flow (DCF) Formula with Templates
Building Blocks of Discounted Cash Flow
But before we talk about how to compute discounted cash flow, here are its most important components:
- Cash Flows: Free Cash Flows to the Firm (FCFF) or Free Cash Flows to Equity (FCFE) for a projection period (generally 5-10 years).
- Terminal Value: A projection of cash flows beyond the forecast period, usually based on a perpetuity growth model.
- Discount Rate: Typically WACC or required rate of return — discount future cash flows.
- Present Value Formula: A formula to discount each future cash flow to its present value today.
The Present Value Formula
Present value calculates how much all future cash flows will be in today dollars. It’s just the basis for the DCF calculation:
PV=CF/ (1+r)n
Where:
- PV = Present Value
- CF = Cash Flow in the future period
- r = Discount rate
- n = Number of time periods in the future
This calculation is used to find the present value of each future cash flow, and then all the present values are added up to find the total discounted cash flow value.
A Guide to the Discounted Cash Flow Formula
Download free cash flow models How to calculate discounted cash flow: Breaking it down step by step
Step 1: Project the Free Cash Flows
Project the free cash flows that the business will produce for the next 5 to 10 years. They can be obtained from profit and loss accounts, balance sheets, and cash flow statements.
Example:
To give an example, let us say a company is expected to produce the following free cash flows all through the next 5 years.
Year 1: $100,000
Year 2: $110,000
Year 3: $120,000
Year 4: $130,000
Year 5: $140,000
Step 2: Finding the Terminal Value
The terminal value represents the amount of value that cannot be captured within the forecasted period. One of the most common approaches is using the Gordon Growth Model:
Recall that the formula for the TV is given by:
TV=CFn1+gr-g
Where:
- TV= Terminal Value
- CFn = Cash Flow in the last year of projection
- g = Perpetual growth rate (3% or so)
- r = Discount rate (e.g. 10%)
Step 3: Discounting Each Cash Flow to its Present Value
Apply the present value formula to determine the present rates of each year cash flow and the terminal value.
Assuming a 10% discount rate:
PV Year 1 = $100,000/ (1 + 10%)^1 = 90,909
PV Year 2 = $110,000/ (1 + 0.10)^2 = 90,909
PV Year 3 = $120,000/ (1 + 0.10)^3 = $90,159
PV Year 4 = $130,000/ (1+0.10)^4 = $88,636
PVYear 5 = $140,000 / (1 + 0.10)^5 = $86,818
PV Terminal Value = $2,060,000 / (1 + 0.10)^5 = $1,278,128
Step 4: Sum Up The Present Values
Total present value of cash flow = Present value of cash flows + Present value of terminal value
Using this information, we can calculate the discounted cash flow as follows:
DCF = 90,909 + 90,909 + 90,159 + 88,636 + 86,818 + 1,278,128 = 1,725,559
Hence, intrinsic value of the company is around $1,730,000.
When to Use DCF
DCF is most effective when:
- Future cash flows can reasonably be estimated.
- The business or asset generates steady, predictable income.
- What you need is a comprehensive, foundational overview of how to value cash flow.
It is especially useful in:
- Equity valuation
- Project feasibility studies
- M&A analysis
- Real estate investments
- Start-up funding scenarios
Drawbacks of Discounted Cash Flow
Despite its benefits, discounted cash flow comes with as many challenges:
- Sensitive to assumptions: Valuations can swing wildly with small changes in discount rates and growth estimates.
- Forecasting difficulty: Predicting cash flows years in future is fraught with uncertainty.
- Sensitivity to Terminal Value: Since the DCF value can be highly sensitive to its terminal value (i.e., the value post the forecasting period), this can create biased results if we misestimate it.
Due to this reason, DCF works better when used in conjunction with other value investing tools and methods of valuation.
Conclusion
Discounted cash flow method as it provides a detailed valuation of an asset based on its expected future cash flows. When done right, it can steer good fiscal judgement, shine a light on missed valuations, and substantiate buy, hold and sell strategies.
Learning about discounted cash flow, means knowing how to project future cash flows, using the present value formula, and determining the terminal value, which gives you a wider scope of view when it comes to evaluating investments. Although DCF has its limitations, it continues to be a gold standard in valuation of cash flows as investments.
This is a powerful tool that you must learn to do if you are a startup founder on the road for funding, financial Analyst making valuations or an investor looking for undervalued assets so that you can have your DCF calculation ready for a long-term success.
