Discounted Cash Flow estimates the value of a business based on the cash flows it will generate in the future. It takes into account that money received today is more valuable than money received several years from now. It can help investors decide whether an investment appears valued, undervalued, or overvalued.
This article explains everything you need to know about Discounted Cash Flow (DCF).
Key Takeaways
- DCF estimates intrinsic value by discounting future cash flows to their value today.
- The time value of money is central because money received today is worth more than the same amount received in the future.
- Future cash flow estimates matter and should be based on realistic business assumptions.
- Terminal value can significantly affect the final DCF valuation.
- DCF is an estimate, not an exact figure, so it should be combined with other valuation methods and sensitivity analysis.
What is Discounted Cash Flow (DCF)?
Discounted Cash Flow is a valuation technique used to calculate the present value of an investment by discounting future cash flows.
The principle behind DCF is the Time Value of Money (TVM).
Example:
Money you receive today is worth more than the same amount received in the future.
If you get ₹1,000 today, you can invest it and earn returns over the next five years.
If you receive the same ₹1,000 five years later, you miss out on those potential earnings.
This concept is called the Time Value of Money (TVM).
The DCF Formula
The present value of a future cash flow is calculated using the following formula:
Present Value = Future Cash Flow ÷ (1 + Discount Rate)^n
Note: n represents the number of years into the future.
Example:
A company expects to receive ₹1,100 exactly 1 year from now.
Your required discount rate (or expected return) is 10% (0.10).
Using the formula:
Present Value = Future Cash Flow ÷ (1 + Discount Rate)^n
Identify the variables:
- Future Cash Flow = ₹1,100
- Discount Rate = 10% (or 0.10)
- $n$ (Number of years) = 1 year
Calculation:
Present Value = ₹1,100 ÷ (1 + 0.10)^1
Present Value = ₹1,100 ÷ 1.10
Present Value = ₹1,000
Also Read About: What Is Net Present Value?
What is Cash Flow and How to Calculate it?
Free cash flow is the cash a company generates after making provisions for the investments required to maintain and grow the business.
It can be calculated using the formula below:
Free Cash Flow = Operating Cash Flow − Capital Expenditure
Example:
If a company generates ₹100 crore from its operations and spends ₹30 crore on new equipment, its FCF would be:
₹100 crore − ₹30 crore = ₹70 crore
So, the company has ₹70 crore in free cash flow available for other uses.
Also Read About: Cash Flow Statement
How Does a DCF Valuation Work?
A DCF valuation usually follows a few major steps.
Step 1: Estimate Future Cash Flows
The first step is to forecast the business's future cash flows. Normally, forecast figures are prepared for several years, usually 5 to 10 years.
The estimation of cash flows is based on the following parameters, among others:
- Revenue growth
- Profit margin
- Operating costs
- Taxation
- Capital expenditures
- Working capital needs
- Industry performance
- Competition
- Economic growth projections
Step 2: Discount Rate Selection
The next step is selecting the discount rate. The discount rate is the expected return on investment, reflecting the risk of investing in the business. A riskier business usually gets a higher discount rate. On the other hand, a less risky business usually gets a lower discount rate.
When valuing a business, WACC (Weighted Average Cost of Capital) is typically used to assess the overall enterprise. The discount rate is critical because a small change can make a significant difference in the resulting DCF valuation.
Step 3: Discount the Future Cash Flows
After estimating future cash flows and the discount rate, each future cash flow is discounted to its present value.
Step 4: Compute Terminal Value
The calculation of terminal value is a critical aspect of any discounted cash flow model. It is impossible to forecast a company's cash flows on a year-on-year basis for eternity.
Step 5: Add the Present Values Together
Add the present value of cash flows and the terminal value to determine enterprise value, then adjust for debt and cash to arrive at equity value.
The equation is as follows:
Enterprise Value = Present Value of Forecast Cash Flows + Present Value of Terminal Value
To convert enterprise value to equity value, the formula is:
Equity Value = Enterprise Value - Debt + Cash
Example:
Company XYZ
Present Value of Forecast Cash Flows (Years 1 to 5): ₹400 million
Present Value of Terminal Value: ₹600 million
Total Debt: ₹150 million
Cash and Cash Equivalents: ₹50 million
Calculation Breakdown
- Calculate Enterprise Value
Sum the present value of the forecast cash flows and the present value of the terminal value.
Enterprise Value = ₹400 million + ₹600 million = ₹1,000 million
- Adjust for Debt and Cash
Apply the equity value formula:
Equity Value = Enterprise Value - Total Debt + Cash and Cash Equivalents
Equity Value = ₹1,000 million - ₹150 million + ₹50 million
Equity Value = ₹900 million
What is WACC and How it is Related to DCF?
WACC refers to the Weighted Average Cost of Capital. It is considered the discount rate when evaluating the firm's future free cash flows.
There are several sources from which a firm may obtain financing, primarily debt and equity. Each source has a certain cost. The WACC accounts for these costs according to their weights in the firm's capital structure.
The formula looks as follows:
WACC = (Weight of Equity × Cost of Equity) + (Weight of Debt × After-Tax Cost of Debt)
More precisely, the formula might be presented, but what matters is that the WACC is the average rate of return that capital sources demand.
If WACC equals 8%, the future cash flows are discounted by 8%.
If the WACC equals 12%, the same future cash flows will be less valuable today.
That is why it is so crucial to choose an appropriate discount rate.
Numeric Breakdown for WACC Calculation
To see how the Weighted Average Cost of Capital is determined in practice, consider a company with a capital structure split between equity and debt using the following parameters:
- Weight of Equity (We): 70% (0.70)
- Cost of Equity (re): 12% (0.12)
- Weight of Debt (Wd): 30% (0.30)
- Pre-tax Cost of Debt (rd): 8% (0.08)
- Corporate Tax Rate (t): 25% (0.25)
Step 1: Calculate After-Tax Cost of Debt
Because interest payments on debt are tax-deductible, the effective cost of debt is reduced by the corporate tax rate:
After-Tax Cost of Debt = 8% × (1 - 0.25)
After-Tax Cost of Debt = 8% × 0.75 = 6% (or 0.06)
Step 2: Apply the WACC Formula
Substitute the weights and costs into the WACC equation:
WACC = (0.70 × 0.12) + (0.30 × 0.06)
WACC = 0.084 + 0.018 = 0.102
The resulting WACC is 10.2%. This figure is then used as the benchmark discount rate to bring the company's future free cash flows back to their present value.
Benefits of Discounted Cash Flow (DCF)
- Focuses on future cash flows: The DCF valuation method relies on expected future cash flows generated by the business, rather than on the firm's past performance.
- Helps estimate intrinsic value: It enables investors to assess the business's intrinsic value and determine whether it is overvalued or undervalued.
- Considers the Time Value of Money: DCF assumes that money received now is worth more than the same amount received in the future.
- Can be customized: The assumptions made about growth, margins, capital expenditure, and discount rates can be tailored according to individual firms.
- Encourages long-term thinking: DCF considers the long-term cash flows rather than short-term market fluctuations.
- Useful for scenario analysis: Investors can develop scenarios, including best-case, base-case, and worst-case.
- Supports business decisions: DCF is useful in evaluating companies, projects, and other business decisions.
Limitations of Discounted Cash Flow (DCF)
- Highly dependent on assumptions: Small changes in growth assumptions can greatly influence the valuation result.
- Difficult to predict the future: Future cash flows can be affected by economic, technological, competitive, and regulatory changes.
- Sensitive to the discount rate: Even small changes in the discount rate can cause large changes in the estimated value.
- Terminal Value has a major impact: Assumptions about long-term growth can significantly affect the valuation.
- Not suitable for every business: It may be difficult to apply DCF to startups, cyclical companies, or businesses with fluctuating or negative cash flows.
- May create false precision: A precise DCF valuation does not guarantee the precision of the actual valuation. A valuation range may be more appropriate.
Conclusion
DCF is a great instrument that allows one to estimate how much a business or investment is potentially worth based on the cash flow it will generate in the future. The most important advantage of DCF is the direct link between valuation and the economic benefits the investment would create.
