Discounted cash flow, or DCF, is a popular method for valuing investments that generate cash flow. It is also a popular valuation methodology for analyzing investments in companies or securities.
The strategy uses a “discount rate” to try to put a current value on predicted future cash flows.
The following is a quick definition of discounted cash flows, the advantages of using DCF values, and how to calculate a DCF.
What is Discounted Cash Flow (DCF)?
The discounted cash flow (DCF) valuation procedure calculates the intrinsic value of an investment, such as a company or a project. It calculates the present value of future cash flows by discounting them at a rate that is indicative of the risk associated with the investment and the time value of money.
In basic terms, DCF implies that the value of money today is greater than that of the same quantity of money in the future as a result of the potential for investment and the impact of inflation. DCF offers a method for comparing the value of future benefits to the cost of the investment today by discounting future cash flows.
How does discounted cash flow (DCF) work?
To use discounted cash flow (DCF), you have to guess how much money an investment will make in the future and then lower the value of those future cash flows so that they are equal to their current value. There are two main steps to this:
- Projecting future cash flows means making guesses about how much money a project will bring in and how much it will cost over its lifetime. Financial models, historical data, and predictions about future market behavior can aid in this process.
- If you want to know how much future cash flows are worth now, you need to use a discount rate to bring them down to their current value. The discount rate takes into account how much money is worth over time and the risk of the business. A higher discount rate means that cash flows in the future are worth less now.
Next, we add up the present value of all the expected cash flows to determine the true value of the investment. If the investment appears undervalued and its true value surpasses its current market price, it could be a favorable moment to purchase. On the other hand, we refer to an investment as overpriced if its true value exceeds its current market price.
What is Discounted Cash Flow Formula?
The formula for Discounted Cash Flow (DCF) is:
Present Value = Future Cash Flow / (1 + Discount Rate)^Number of Periods
Where:
- Present Value: The current value of a future cash flow.
- Future Cash Flow: The expected cash flow in the future.
- Discount Rate: The rate used to discount future cash flows to their present value.
- Number of Periods: The number of time periods between the present and the future cash flow.
To calculate the overall present value of an investment, one typically adds the present values of all anticipated future financial flows.
Pros and Cons of Discounted Cash Flow (DCF)
| Pros | Cons |
|---|---|
| Intrinsic Value: Provides an estimate of a company’s true value based on its expected cash flows. | Sensitive to Assumptions: The accuracy of DCF depends heavily on the accuracy of projected cash flows and the discount rate. |
| Flexibility: It can adapt to a variety of investment scenarios and industries. | Complexity: DCF calculations can be complex and time-consuming, especially for long-term projections. |
| Forward-Looking: Focuses on future cash flows, making it a more forward-looking valuation method than historical metrics. | It requires accurate forecasting of future cash flows, especially in uncertain economic environments. |
| Comparable Valuation is a useful tool for comparing the valuations of similar companies or industries. | Subject to Market Sentiment: Even if a company is undervalued based on DCF, market sentiment can still influence its stock price. |
| Decision-Making Tool: Provides a framework for evaluating investment opportunities and making informed decisions. | May Not Reflect Short-Term Fluctuations: DCF focuses on long-term value, which may not account for short-term market volatility. |
Why is Discounted Cash Flow Important?
Discounted Cash Flow (DCF) is important because it provides a comprehensive and forward-looking method for valuing investments. DCF helps investors determine an asset’s intrinsic worth by forecasting future cash flows and discounted them back to present value, regardless of its current market price. When short-term factors or emotional biases have an impact on market prices, this can be especially helpful.
Additionally, you can use DCF to compare the values of different investment opportunities, find undervalued assets, and make wise investment decisions. It’s a popular instrument in corporate finance, investment banking, and other industries where valuation is important.
What Do You Mean by the Terminal Value in DCF?
Terminal value in Discounted Cash Flow (DCF) is the predicted worth of a company’s cash flows after the projection period. In essence, it represents the value of a company’s cash flows once future cash flows become difficult to predict.
There are two main approaches for calculating terminal value:
- Perpetuity Growth Model: This model assumes that the company’s cash flows will increase at a steady rate indefinitely. We compute the terminal value using the following formula:Â Terminal Value = FCF * (1 + g) / (r – g), where FCF is the free cash flow in the previous projected year, g is the perpetual growth rate, and r is the discount rate.
- Exit Multiple: This strategy implies that the company will be sold for a multiple of its earnings or EBITDA, in the final year. We compute the terminal value by multiplying the earnings (or EBITDA) of the terminal year by the projected exit multiple.
The distinctive characteristics of the business and industry determine the approach. Both strategies require making assumptions about future growth and valuation, which can impact the company’s overall value.
Also Read:
- What is PEG Ratio in Share Market? Balancing Price, Earnings, and Growth
- What Are Preferred Dividends And How Can They Benefit You?
How to Value Stocks Using DCF?
To value equities with Discounted Cash Flow (DCF), follow these steps:
- Project Future Cash Flows: Determine the company’s future free cash flows over a given time period, often 5-10 years. This includes projecting revenue, spending, capital expenditures, and other important factors.
- Determine Discount Rate: Select a discount rate that reflects the risk of the investment. We commonly estimate this using the Weighted Average Cost of Capital (WACC).
- Calculate the present value of cash flows: Discount each future cash flow to its present value using the discount rate and the formula: To calculate present value, divide future cash flow by (1 + discount rate) times the number of periods.
- Calculate Terminal Value: Using either the continuous growth model or the exit multiple technique, determine the value of the company’s cash flows after the projection time.
- Sum Present values: To calculate the company’s total intrinsic value, add the present values of the predicted cash flows to the terminal value.
- Compare to Market Price: In step 5, calculate the intrinsic value and compare it to the stock’s current market price. A higher intrinsic value could indicate an undervaluation of the stock. A lower intrinsic value could indicate an overvaluation of the stock.
Why Would You Use a DCF Model?
Use a Discounted Cash Flow (DCF) model to:
- Estimate Intrinsic Value: DCF is a comprehensive approach to analyze a company or investment that focuses on its future cash-generating potential.
- Compare Investments: By using DCF to value different investments, you can determine which ones provide the best returns for the risk.
- Make Informed Decisions: Using DCF, you may decide whether to buy, sell, or keep investments based on their intrinsic value.
- You can use DCF to evaluate a potential acquisition target and determine a fair purchase price.
- Assess Company Performance: By comparing a company’s actual performance to its DCF-based valuation, you may determine how well it generates value for its owners.
Strengths of a Discounted Cash Flow Analysis
Discounted cash flow analysis (DCF) offers numerous advantages.
- Intrinsic Value: It gives a full estimate of a company’s future cash flows, delivering an intrinsic value that is unaffected by market sentiment.
- Flexibility: DCF may be customized for numerous industries and firm types, making it suitable for a variety of investment circumstances.
- Forward-Looking: It focuses on a company’s future cash flows, offering a more forward-looking perspective than historical data.
- Use DCF as a decision-making tool to evaluate investment opportunities, compare valuations, and form wise decisions.
- Comparable Valuation: This method provides a relative perspective by comparing the valuations of similar companies or industries.
