The first thing you check when you are buying something is the price tag. But what if you are purchasing a business or investment that is expected to grow and generate cash? Discounted cash flow (DCF) helps answer that question by estimating the present value of all future cash flows the business is expected to generate.
It helps you figure out what future money is actually worth today. This approach will provide a better vision of whether an investment is a good deal at all. In this blog, we will explain what discounted cash flow is, how it works, its formula and calculator process, and different techniques of performing it.
Table of Contents:
Understanding Discounted Cash Flow (DCF)
The discounted cash flow method estimates the future earnings and discounts them back to the present. The important concept is the time value of money. Inflation and other factors make a rupee today worth more than one tomorrow.
However, DCF is a widely used method in business valuation. It can also serve as a handy means to determine whether capital investments, such as new equipment or expansion, will be worth it in the long run. By comparing the present value of return to the initial cost, you can decide if the investment is worthwhile.
For example, when you consider purchasing a business or investing in shares, DCF will allow you to determine whether the projected returns are worth the amount paid. It is also used by business owners to make decisions as to whether a major expenditure will be worth the returns or not.
Why is Discounted Cash Flow Important?
Discounted Cash Flow is an effective tool since it allows you to evaluate more deeply. It decomposes the value of an investment into present value terms that regard future income as well as risks. Why does that matter? Here is why:
- Helps in making better decisions: DCF provides you with a clear, user-friendly method of determining whether an investment is desirable or not.
- Shows the true value of an asset: It will tell you the actual value of an asset, so that you can know whether to see it as an overpriced asset or a cheap asset.
- Accounts for risk: It helps you to know the possibility of making or losing money, as DCF considers the riskiness of an investment.
How Does Discounted Cash Flow (DCF) Work?
Discounted Cash Flow (DCF) is a method used to estimate the present value of an investment based on its expected future cash flows. These future cash flows are adjusted using the concept of time value of money, which means that a rupee today is worth more than a rupee in the future because it can be invested to earn returns.
To perform a DCF analysis, you forecast the future cash flows and then discount them back to today using a discount rate. The higher the discount rate, the lower the present value of future cash flows. If the total present value is greater than the initial investment cost, the opportunity may be financially attractive.
3 Key Components of DCF Analysis
The following are the key inputs in DCF computation that directly affect its accuracy.
1. Cash Flows in the Future
Projected cash flows represent the future income the investment is expected to generate in the form of revenues less operating expenses, taxes, capital expenditures, and working capital changes.
2. Discount Rate
The rate indicates the risk of the investment and the minimum rate of return that investors are willing to earn. It is deployed to transform future cash flows into current value.
3. Present Value
Future cash flows are discounted to obtain their present-value equivalent by using the discount rate. The sum of these provides the intrinsic value of the investment.
Steps to Calculate Discounted Cash Flow
Follow these steps to calculate the discounted cash flow of an investment:
Step 1: Project Future Free Cash Flows (FCF)
Forecast the company’s free cash flows over a period, typically 5 to 10 years. Start with the revenue forecasts. Then, subtract operating costs, taxes, capital expenditures, and changes in working capital. The result you get is the company’s projected free cash flow for that year.
Step 2: Choose the Discount Rate
Typically, the Weighted Average Cost of Capital (WACC) is used as the discount rate. It reflects the average return expected by equity and debt holders.
However, WACC may not be the best choice if you are valuing an equity-only investment, like estimating a stock’s true value. In that case, it’s better to use the required rate of return for equity (also called the cost of equity), which reflects only the risk shareholders face.
Step 3: Discount the Projected Cash Flows
Adjust each year’s free cash flow by dividing it by (1 + discount rate) raised to the year number. This accounts for the time value of money.
Step 4: Calculate the Terminal Value
Estimate the value of cash flows beyond the forecast period using either:
Step 5: Discount the Terminal Value
- Perpetuity growth method:
Terminal Value = Final year FCF × (1 + g) ÷ (WACC – g), where g is the growth rate.
- Exit multiple method:
Multiply the final year’s earnings (e.g., EBITDA) by an industry multiple.
Bring the terminal value back to present value using the discount rate.
Step 6: Add Them Up
Sum the present values of the forecasted free cash flows and the discounted terminal value to get the enterprise value.
Step 7: Adjust for Debt and Cash
- Subtract net debt (total debt minus cash) to get equity value.
- Divide by the number of shares outstanding to find the intrinsic value per share.
The Discounted Cash Flow formula is:
DCF = [Cash flow for the 1st year / (1 + r)1] + [Cash flow for the 2nd year / (1 + r)2] + [Cash flow for the 3rd year / (1 + r)3] + .. + [Cash flow for the nth year / (1 + r)n]
Where:
- CF1,CF2,…CFn are the cash flows for years 1 to n.
- r is the discount rate.
- Each cash flow is divided by (1+r) raised to the power of its year number, discounting it back to present value.
This formula discounts each expected cash flow back to its present value, reflecting the time value of money. Adding all discounted cash flows gives the investment’s present value, which helps assess whether it is financially possible.
Now that you understand the formula well, let’s look at the practical discounted cash flow example.
Example of Discounted Cash Flow (DCF)
Let’s apply the discounted cash flow formula with a simple example:
Ms. Geetanjali is considering investing ₹2,50,000 in a small manufacturing unit. She expects the business to generate the following free cash flows over the next 5 years:
| Year |
Expected Cash Flow (₹) |
| 1 |
40,000 |
| 2 |
50,000 |
| 3 |
60,000 |
| 4 |
70,000 |
| 5 |
80,000 |
The discount rate (WACC) for this investment is 8%.
To calculate the present value (PV) of each cash flow, use:
DCF = [Cash flow for the 1st year / (1 + r)1] + [Cash flow for the 2nd year / (1 + r)2] + [Cash flow for the 3rd year / (1 + r)3] + .. + [Cash flow for the nth year / (1 + r)n]
Calculating each term:
| Year |
Cash Flow (₹) |
Discount Factor (1 + r)^t |
Calculation |
Present Value (₹) |
| 1 |
₹40,000 |
1.08 |
₹40,000/1.08 |
₹37,037 |
| 2 |
₹50,000 |
1.1664 |
₹50,000/1.1664 |
₹42,871 |
| 3 |
₹60,000 |
1.2597 |
₹60,000/1.2597 |
₹47,628 |
| 4 |
₹70,000 |
1.3605 |
₹70,000/1.3605 |
₹51,514 |
| 5 |
₹80,000 |
1.4693 |
₹80,000/1.4693 |
₹54,015 |
Sum the discounted cash flows:
DCF = ₹(37,037 + 42,871 + 47,628 + 51,514 + 54,015) = ₹2,33,065
Since the total discounted cash flow (₹2,33,065) is less than the initial investment (₹2,50,000), this suggests the investment may not be financially attractive.
To calculate the intrinsic value of a company, you can use a discounted cash flow calculator, which easily calculates the fair value of investments.
Key Assumptions in DCF Analysis
Discounted cash flow valuations often fall apart even before you begin calculating. Why? That’s because many DCF assumptions are difficult to get right. Get these four right and your valuation will work.
1. Revenue and Cost Forecasts
Your FCF projections are very sensitive to revenue and cost projections. Minor errors in this case can accumulate as time progresses and disturb the respective value. Pay attention to recent financials, price and market trends, how the company can become more efficient, etc. Also, ensure to review the performance of the entire industry to make your estimates at the right level.
2. Discount Rate
The discount rate converts the cash flows that are in the future into the present day. The faster the rate the lower those future cash flows become today. WACC blends the cost of debt and equity, weighted by their proportion in the capital structure. Typically, equity is riskier, so it demands a higher return. Debt is safer, so it requires a lower rate.
3. Terminal value
Terminal value can often make up a large portion, i.e., more than half of the overall DCF output. It captures the value of all cash flows beyond the forecast period. If you get the wrong figure with this number, your entire findings could be wrong. In most cases, you estimate it on a model of a stable rate of growth or use an industry multiple against your last year’s figures. Be sure to take it back to present value by means of the discount rate.
The choice between the perpetuity method and the exit multiple method depends on industry predictability and the availability of comparable data.
4. Growth rates
Your cash flow projections and final worth are formed by growth rates. Provided they are not very realistic, you will not have an accurate assessment. Base your assumptions on previous performances, industry trends, as well as the economy. Being very optimistic or pessimistic is not good; it should be balanced.
Major Advantages of Discounted Cash Flow Analysis
This is why DCF is well-liked by most investors and analysts.
1. Accuracy: DCF gives an effective and thorough value depending on reasonable assumptions.
2. Flexibility: It can be used in a broad variety of investment types- stock and business investment, real estate, and projects.
3. Time Value of Money: DCF is the right way to handle the facts that money has greater value today as compared to that same amount of money in the future.
4. Focus on future returns: This is because one can maintain a clear picture of the long-term potential of an investment by directly looking at what future cash flows are expected.
5. Adaptable: You can modify cash flow projections and discount costs to individual industries, projects, or risk classes.
6. Objective: It helps investors in making data-driven conclusions, as it does not depend on market mood or personal opinion. It depends on measurable cash flows and discount rates.
Key Limitations of Discounted Cash Flow Analysis
Below are some of the disadvantages of DCF analysis:
1. Highly Sensitive to Assumptions: These kinds of assumptions about cash flow forecasts or discount rates cause large changes in valuation, even in the case of a small change in other things.
2. Forecasts: It is hard to predict cash flows for volatile businesses or startups.
3. Over-Reliance on Long-Term Assumptions: DCF relies on estimating value beyond the forecast period, which often involves long-term assumptions.
4. Complexity: Estimating discount rates and future cash flows often involves subjective judgment.
5. Not suitable for every asset: DCF is not suitable for all assets, especially volatile businesses with an irregular cash flow. It is less suited to startups or highly volatile industries where the earnings are not at all regular.
Different Discounted Cash Flow Techniques
Discounted Cash Flow can be performed in quite a number of ways, depending on what you are valuing and how detailed you require.
The key discounted cash flow techniques are the following:
1. Standard (Free Cash Flow) DCF
This is the most widespread one. You predict the firm’s (FCFF) free cash flows over a certain time frame and discount back with the WACC, then you get a terminal value for it. It is more suitable for experienced firms that experience predictable cash flows.
2. Dividend Discount Model (DDM)
Employed mostly in the case of companies that pay constant dividends. You discount expected dividends as opposed to free cash flows. It is easier and useful when the company consistently pays dividends and results are predictable.
3. Adjusted Present Value (APV)
This approach lies in separating the value of a firm with no debt from the tax shield benefits of debt. You value the company at an all-equity state of finances, then you add the present value of tax or shields. It comes in handy when there are changes in the capital structure or when there are large amounts of debt.
4. Excess Returns Model
Concentrates on economic profits or returns above the cost of capital to the company rather than on cash flows. The method is more intricate, and it is usually used on firms that have intangible assets or uncommon cash flows.
5. Real Options Valuation
Real options valuation incorporates flexibility by involving future decision-making under uncertainty. It particularly comes in handy in projects or firms when there is high ambiguity and strategic decisions to be made.
The two techniques apply to varying situations. The usual FCFF DCF should be used most of the time, yet being knowledgeable about the others will enable you to adjust your valuation to a particular scenario.
Discounted Cash Flow vs Other Valuation Methods
Different valuation methods depend on the purpose and data available. DCF estimates intrinsic value with a discount on the anticipated upcoming cash flows, which is ideal with companies that have consistent earnings.
Comparable Company Analysis and Precedent Transactions are based on the availability of comparable market information, as well as prices of deals, and are more rapid, yet in some instances less accurate estimates.
Asset-Based Valuation concentrates on the tangible assets, and it fits liquidation or asset-intensive companies. The selection of the approach must be related to the situation and available data.
Discounted Cash Flow Analysis for Small Businesses Valuation
Small businesses tend to have uncertain cash flows and short histories of financial performance, although DCF can still be effective if you follow these guidelines:
- Determine cash flows of the project realistically over a 3 to 5-year horizon, depending on historical performance and the market. If historical data is not sufficient, then industry averages or comparable data may also be used.
- Choose a discount rate that indicates the additional levels of riskiness typical of small businesses.
- Estimate the long-term value using a steady growth rate or by comparing similar businesses.
- Enterprise value is the sum of the discounted cash flows plus terminal value.
- To get the value of the equity, adjust for debt and cash.
Use conservative and well-founded assumptions, as small businesses are more sensitive to forecasting errors.
Conclusion
Finally, discounted cash flow analysis is an important method of estimating the value of investments by calculating the present value of expected future cash flows. Whether you are a business owner, investor, or finance professional, understanding DCF assists you in making more data-driven decisions. It helps evaluate real value by weighing future returns against risk. Excelling in DCF puts you in a strong position to see beyond market trends to spot true potential.
What is Discounted Cash Flow – FAQs
1. Where can the discounted cash flow method be used?
Businesses, projects, real estate, stocks, and any investments in which the cash flows can be reasonably forecasted in the future and valued. It is extensively used in financial equity analysis, corporate finance, and mergers and acquisitions.
2. When is DCF analysis most useful?
DCF can be most useful in valuing companies or projects that have extremely predictable and measurable cash flows, either well-established businesses or long-term investments. It is not suitable for startups or highly volatile activities with uncertain cash flows.
3. How to use discounted cash flow to make smarter investment decisions?
DCF helps you in evaluating the intrinsic value of an investment by comparing the future expected cash flows to the current price of the investment by discounting its expected future cash flows to the present value. It indicates whether an asset is underpriced or overpriced, so that the buying and selling of the asset can be done in a more informed manner.
4. Is discounted cash flow the same as net present value (NPV)?
Discounted Cash Flows and net present value are closely related, but they are not the same thing. Analysts use the DCF method to estimate the present value of projected future cash flows. NPV is the output you get when you subtract the initial investment from the present value. If NPV is positive, the investment may be worth it, and vice versa.
5. How to value a stock using the DCF model?
Base/Estimate the future free cash flows of the company, discount these cash flows up to the present value with the suitable discount rate (generally WACC), find the terminal value, and add the whole finding to arrive at the enterprise value. Adjust the debt, then divide by the number of shares to get the pre-share value.
6. What is the difference between discounted and non discounted cash flow methods?
The discounted cash flow accounts for the time value of money by converting future cash flows into present value. Non discounted cash flow method does not include the time value of money, leading to an overestimation of an investment.
7. What is a good discount rate to use for DCF?
The discount rate ought to capture the risk and the opportunity cost of the investment. Most firms use Weighted Average Cost of Capital (WACC) as the standard discount rate. Riskier investments would demand higher discounting rates, while safer ones would require lower rates.