Discounted Cash Flow

Discounted cash flow, or DCF, is a common method of valuing investments that produce cash flows. It is also a common valuation methodology used in analyzing investments in companies or securities.

The approach attempts to place a present value on expected future cash flows with the assistance of a “discount rate”.

Below is a brief definition of discounted cash flows, the benefits of using DCF valuations, and the basics of calculating a DCF.

What Is a discounted cash flow?

Discounted cash flow is a valuation technique that uses expected future cash flows, in conjunction with a discount rate, to estimate the present fair value of an investment. It is a calculation that is concerned with the time value of money, or TVM.

TVM is the idea that money today is worth more than money tomorrow. This assumption is based on the premise that today’s dollars could be invested and therefore appreciate in value over time. Time value of money is a pillar concept of modern finance. 

DCF analysis is a useful technique to evaluate any investment that requires a present day cash outlay in exchange for future earnings.

Why is discounted cash flow Important?

Discounted cash flow models are used to estimate the value of an asset. It is considered a fundamental analysis technique, meaning it is both quantitative and qualitative in nature.

DCF models require detailed assumptions that are used to forecast future cash flows. In drafting these assumptions analysts put a great deal of effort into identifying economic, environmental, and social issues that impact future free cash flow.

Because of this, Discounted cash flow analysis is seen as comprehensive and is widely viewed as an industry standard in estimating the fair value of an investment.

Discounted cash flow calculations also rely on a wide variety of data, including cost of equity, the weighted average cost of capital (WACC), and tax-rates.

WACC is, “A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted.
All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation”

The DCF model relies on free cash flow (FCF), which is a reliable metric that reduces the noise created by accounting policies and financial reporting. 

One key benefit of using discounted cash flow valuations over a relatively comparable market approach is that the calculation is not influenced by marketwide over or under-valuation.

Accurate assumptions are critical in a discounted cash flow model; otherwise, the model tends to lose its effectiveness.

How to Calculate Discounted Cash Flows

Because Discounted cash flow models depend on free cash flow, calculating a DCF is both a progressive and cumulative process. 

How to calculate free cash flow (FCF)

Free cash flow is the amount of cash a business creates after considering all cash outflows. One of the impacts accounting policies have on financial statements is the implication of non-cash expenditures.

FCF is a measurement of profitability that eliminates these non-cash expenses and includes cash expenses for acquiring assets and changes in working capital over a given period of time. 

The formula for calculating FCF is:

FCF = cash flow from operations + interest expense – tax shield on interest expense – capital expenditures (CAPEX).

There are other ways to calculate FCF, including:

FCF = [EBIT x (1-Tax Rate)] + non-cash expenses – change in current assets/liabilities – CAPEX

And:

FCF = net income + interest expense – tax shield on interest expense + non-cash expenses – change in current asset/liabilities – CAPEX

Any of these formulas is appropriate depending on what information is available. 

How to calculate Discounted cash flow

Once free cash flow is calculated, it can be used in the DCF formula. As mentioned, the Discounted cash flow formula relies on a discount rate.

In this context, the discount rate is the required rate of return an investor seeks to gain from paying today for future cash flows. 

Analysts often use a business’s weighted average cost of capital (WACC), a required rate of return, or market averages.

The basic formula for calculating discounted cash flows is:

Where:

FCF = FCF for a given year

FCF₁ = FCF year 1

FCF₂ = FCF year 2

FCF_n = each additional year

n = additional year

r = Discount Rate

Using WACC in a Discounted cash flow

When an organization is reviewing multiple investment opportunities it is typically prudent to use Working Average Cost of Capital , or WACC, as the discount rate in the DCF formula. WACC takes all of the components that make up  working capital and proportionately weights them to arrive at an average cost of capital. 

WACC is calculated as follows:

Where:

E = Market value of the business

D = market value of the businesses debt

V = E + D

Re = Cost of equity

Rd = Cost of debt

Tc = Corporate tax rate

WACC is an extensive topic that’s worth mentioning here because it is the industry best practice for assessing an appropriate discount rate when analyzing various projects within an organization.

Other DCF Considerations

Since DCF analysis is so dependent on the use of an accurate discount rate, a great deal of care should go into identifying the appropriate one.

Investors will often use the required rate of return in conjunction with market conditions that are being displayed. In certain cases, a blended discount rate might be used that reflects various scenarios.

Using Datarails to Build Your DCF Model

Every finance department knows how tedious building a discounted cash flow model can be. Regardless of the budgeting approach your organization adopts, big data is required to ensure accuracy, timely execution, and, of course, monitoring.

Datarails’ FP&A software is an enhanced data management tool to help your team create and monitor budgets faster and more accurately.

By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of Excel with the support of a much more sophisticated data management system behind you.
This takes budgeting from time-consuming to rewarding.

Discounted Cash Flow: FAQs

Is DCF the Same as NPV?

DCF (discounted cash flow) and NPV (net present value) have many similarities but aren’t the same.

DCF is the present value of a series of expected future cash flows, discounted back to the present using a set discount rate. It illustrates the combined worth of future cash flows in today’s terms.

NPV extends DCF by including the initial investment or outflow. Most simply, NPV is the DCF value minus the initial investment: NPV = DCF – Initial Investment.

If NPV is positive, that’s usually a sign the investment is profitable. DCF tells you how much today’s cash flows will be worth in the future. 

While DCF tells you the current worth of future cash flows, NPV paints a more complete picture by also accounting for the cost required to achieve those cash flows.

What are the Advantages Of Discounted Cash Flow?

• Considers Intrinsic Value: As future cash flows drive the discounting in DCF, the valuation is intrinsic rather than driven by market trends or comparable companies.
• Assesses the Time Value of Money: DCF discounts future cash flows, reflecting that a given amount of money today is worth more in the future and better captures that value over time. 
• Adaptable to Different Scenarios: You can change the discount rates and projected cash flows to make DCF adaptable to different scenarios and risk levels. These features are useful for scenario planning and stress testing.
• Good for Long-Term Decisions: DCF requires a projection of expected returns over several months or years, which is especially helpful for assessing long-term projects or investments, such as large infrastructure projects or company acquisitions.

What are the Disadvantages Of Discounted Cash Flow?

• Highly Sensitive to Assumptions: DCF depends on assumptions about future cash flows and discount rates. Small changes can greatly impact the value, which can be inaccurate if the projections are off.
• Subject to Accurate Data and Forecasts: As with most valuation models, if you can’t accurately predict or estimate the future, your DCF calculation will be useless. DCF requires a company’s future cash flows and growth rates to be accurately predicted. 

If your subject company works in a volatile industry with a dynamic economic environment, it will be difficult to forecast all the necessary factors with any certainty.

• Complicated and Time-Consuming: DCF is complicated and requires detailed industry understanding. It tends to be more time-consuming than a comparable company analysis or a market-based valuation. 
• Might Ignore External Market Factors: Because DCF looks at intrinsic value, it can overlook market sentiment, competitor actions, and industry trends that might impact an investment’s actual value or attractiveness.

When Should You Not Use a DCF?

DCF analysis doesn’t necessarily represent the best valuation technique in every scenario. 

Some of the more common instances where DCF doesn’t apply include:

• Highly Uncertain Cash Flows: If a company’s future cash flows are exceptionally uncertain (for example, early-stage startups and high-growth tech companies), DCF might be highly unreliable.
• Major Shifts Ahead: If a company is poised to undergo major changes such as a restructuring, a merger, or the launch of a big product, DCF won’t accurately reflect future cash flows or risk.
• Duration of Investment: A DCF will not be very valuable for investments with shorter time periods. Relative valuation ratios might be better for a short-term investment, such as the price-to-earnings (P/E) ratio or price-to-sales (P/S) ratio.
• Dependence on External Factors: Certain industries may be poor candidates for DCF due to the difficulty of projecting cash flows and setting an appropriate discount rate based on external market factors. These can include commodities or companies with significant exposure to fluctuating interest rates and inflation. 
• Not Enough Historical Data: DCF requires reliable data on past performance to build a model for expected future cash flows. Accuracy in a company’s model will be difficult to achieve when not enough historical data is available.

What if the Discounted Cash Flow is Negative?

In this case, a negative DCF number would generally mean the present value of future cash flows is less than the initial investment or the current valuation. 

Here’s what it might suggest:

• Unprofitable Investment: The project or asset simply isn’t worth investing in because the returns it is likely to generate do not compensate for the costs involved.
• High Risk, Low Growth: It can also mean the company or project is risky, has declining cash flows, or has extremely low growth prospects.
• Adjustments May Be Needed: Sometimes, this could signal reassessing certain assumptions. For example, adjusting the discount rate, updating cash flow projections, or revisiting economic factors might provide a more realistic picture.

What Companies Are Not Ideal for a DCF?

DCF is best suited to companies with predictable and stable cash flows. 

Companies where DCF is less ideal include:

• Startups: Revenue is often negligible, or it’s too early to see growth and stability in cash flows, so DCF can be difficult to apply.
• High-Growth Tech or Biotech Firms: These companies tend to have rapid growth, substantial reinvestment requirements, and volatile cash flows. When they have a long-term strategy, it often changes substantially from one year to the next. 
• Cyclical Industries: Companies in energy, mining, agriculture, and some other industries can suffer from high cash flow variability due to fluctuations in commodity prices and business cycles.
• Financial Institutions: Banks and insurance companies have unique cash flow structures, which make DCF difficult. As a result, relative valuation methods such as price/book (P/B) ratios tend to be considered instead.
• Distressed or Restructuring Companies: Businesses going through a major reorganization typically have no predictable cash flows and are, therefore, unsuitable for a DCF model. This might include companies changing their product line or portfolio, undergoing a major expansion, or experiencing financial distress. 

DCF works best for mature companies with stable, predictable cash flows. For most others, a different valuation approach is likely to be more accurate and reliable.