The DCF method can be utilised to estimate the value of:
- A business
- Real estate
- Stocks
- Bonds
- Long-term assets
- Equipment
How does discounted cash flow work
The DCF analysis determines the present value of anticipated future cash flows by applying a discount rate. This helps investors assess whether the projected cash flows from an investment or project will exceed the initial amount invested. In simple terms, DCF analysis asks whether the future income generated by the investment is likely to outweigh the cost of the investment made today.
If the present value of future cash flows is greater than the initial investment, the investment is potentially profitable and worth considering. If not, it may be wise to look for alternative options.
The DCF method is particularly useful for evaluating how much an investor may receive from an investment, adjusted for the time value of money. The time value of money principle assumes that funds available today are more valuable than the same amount received later, as they can be invested to generate returns. Thus, a DCF analysis is useful in any scenario where an initial expenditure is expected to yield higher returns in the future.
For instance, consider an investment with a 5% annual interest rate. If Rs. 100 is invested in a savings account today, it would grow to Rs. 105 after one year. Conversely, if a payment of Rs. 100 is postponed for a year, its present value would be approximately Rs. 95, as the opportunity to earn interest on it has been lost.
To carry out a DCF analysis, an investor needs to estimate future cash flows along with the final value of the asset, business, or investment. Additionally, an appropriate discount rate must be selected, tailored to the specific project or investment. The chosen discount rate depends on factors like the investor’s risk tolerance and prevailing market conditions.
However, DCF analysis may be less effective when future cash flows are difficult to predict, or the project involves high complexity. In such cases, DCF’s accuracy may be limited.
What is DCF formula
The basic formula for calculating discounted cash flow (DCF) is as follows:
Components of the formula:
CF (Cash flows)
- Represents the expected future cash flows generated by the investment over multiple periods (n).
r (Discount rate)
- Reflects the investor's required rate of return or the cost of capital.
- It represents the rate at which future cash flows are discounted to their present value.
n (Time periods)
- Indicates the number of periods into the future for which cash flows are projected.
- Each cash flow (CF) is discounted back to its present value for the respective time period (n).
How to calculate discounted cash flows
Let us understand how to calculate DCF in simple, easy-to-understand steps:
Step I: Forecast future cash flows
- The first step in DCF is to forecast the future cash flows expected to be generated.
- These cash flows typically include:
- Revenues
- Operating expenses
- Capital expenditures, and
- Taxes
Step II: Determine the discount rate
- The discount rate is often referred to as the "required rate of return" or "discount factor,"
- This rate is of paramount importance and reflects:
- The level of risk associated with the investment
- The minimum rate of return that investors expect to earn from the investment
Step III: Apply the discounting formula
The future cash flows forecasted in step I are then discounted back to their present value using the following formula stated above.
Step IV: Sum present values
The present values of all future cash flows are calculated and summed together to determine the total present value of the investment.
Let’s understand better through a hypothetical example:
Consider that you are willing to start a new business and are expecting the following cash flows over the next 5 years:
| Year 1 |
Year 2 |
Year 3 |
Year 4 |
Year 5 |
| Rs. 1,00,000 |
Rs. 1,50,000 |
Rs. 2,00,000 |
Rs. 2,50,000 |
Rs. 3,00,000 |
You are also expecting to earn a minimum of 10% p.a. rate of return. Let’s calculate the DCF:
Year
|
Cash flow (Rs.)
|
Discount factor (1 + 0.10)^n
|
Discounted Cash flow (Rs.)
|
1
|
100,000
|
(1 + 0.10)^1 = 1.10
|
90,909.09
|
2
|
150,000
|
(1 + 0.10)^2 = 1.21
|
124,793.39
|
3
|
200,000
|
(1 + 0.10)^3 = 1.331
|
160,925.17
|
4
|
250,000
|
(1 + 0.10)^4 = 1.4641
|
191,079.55
|
5
|
300,000
|
(1 + 0.10)^5 = 1.61051
|
203,857.55
|
Total
|
-
|
-
|
771,564.65
|
What are the advantages of discounted cash flow analysis?
- Investment evaluation: DCF analysis offers investors and companies a useful projection to determine if a proposed investment is likely to be profitable, enabling informed decisions.
- Applicable to various projects: DCF is versatile, suitable for assessing a wide range of investments and capital projects where future cash flows can be estimated with reasonable accuracy.
- Adjustable scenarios: One of DCF’s key benefits is its flexibility; scenarios can be adjusted to explore different “what-if” situations, allowing users to test multiple outcomes and account for variable forecasts.
What are the disadvantages of discounted cash flow analysis?
- Involves estimates: A major limitation of DCF is its reliance on estimates rather than precise data, meaning the results are approximate. This requires investors and companies to carefully estimate both the discount rate and future cash flows.
- Unforeseen economic changes: DCF analysis depends on factors such as economic conditions, market demand, competition, and technological shifts, which are often unpredictable. These elements introduce uncertainty, making projections less reliable.
- Shouldn't be used in isolation: Even with accurate estimates, DCF should not be the sole evaluation tool. It is best complemented with other valuation methods, like comparable company analysis or precedent transactions, for a more comprehensive assessment of investment opportunities.
Conclusion
Discounted cash flows (DCF) is a widely used fundamental analysis method used by investors to assess the potential value of an investment. This method is based on the concept of time value of money (TVM), which states that the worth of a rupee today is higher than the worth of a rupee revived in future.
By applying a minimum rate of return, investors can bring the projected cash flows back to their present value and calculate an intrinsic value. Applicable for both long-term and short-term investments, DCF empowers investors to assess the potential value of investments with greater clarity and confidence.
Read other interesting articles
