Discounted Cash Flow

Discounted cash flow, or DCF, is a technique that helps investors determine an investment’s present value by considering its future cash flows. With the help of DCF, investors can gauge the value of the investment required to receive fixed returns.

The core of discounted cash flow is built on the idea of the time value of money. According to this concept, the money an individual possesses now has more value than the same amount in the future.

• The DCF method helps investors predict the present value of an investment as long as its future cash flow values can be determined.
• DCF can be used in businesses, stocks, bonds, real estate, etc.
• The method is versatile and also helps determine an investment’s intrinsic value.

There are many areas where DCF can be used. These include:

• Businesses
• Stocks
• Real estate
• Bonds

Explained below is the discounted cash flow formula:
 

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]

Here:

1. Cash flow:
   • Combines both fund inflows and outflows
   • Represents principal and dividend payments in the case of bonds.
   • Can be represented as CF1 first-year cash flow, CF2 second-year cash flow, etc.
      
2. r:
   • Represents the discount rate.
   • Represents the weighted average cost of capital in businesses.
   • The weighted average cost includes the average of a firm’s working capital without taxes.
   • Investors expect this discount rate from a firm to finance their assets.
   • ‘r’ represents the rate of interest in the case of bonds.
      
3. n:
   • Represents the final years.
   • DCF can help predict long-term valuation extending up to more than a decade.

Before investors calculate the DCF, they need to calculate the weighted average cost of capital or WACC.
 

This is where the formula for calculating WACC helps out:
 

WACC = ((E / V) x Re) + [(D / V) x Rd x (1 - Tc)]
 

Here:

1. E:
   • The market value of the businesses’ equity
2. D:
   • The market value of the businesses’ debt
3. Re:
   • Equity’s cost
4. V:
   • Represents E+D or the business’ total financing value
5. Rd:
   • Debt’s value
6. Tc:
   • The tax corporate’s rate

The final determinant at the end of the DCF formula is known as the terminal value. It represents the expected growth rate of the cash flows beyond the considered period.

The terminal value can be calculated using two specific methods:

1. The Exit Multiple Method
   • Here, any specific financial criterion of a business, like its EBITDA, is multiplied by a trading multiple.
2. The Perpetuity Method
   • Here, the terminal value calculation formula = [FCWnx (1 + g)] / (WACC – g)
     Where,
     FCF = free cash flow and
     ‘g’= perpetual growth rate of FCF

There are quite a few benefits to the DCF method. Some of them are listed below:
 

1. Versatility:
   • DCF is an extremely versatile method as it can be used for firms, projects, and other investments
   • However, this solely depends on the ability to predict future cash flow trends of the said investment.
      
2. Determines an investment’s intrinsic value:
   • The intrinsic value of an investment showcases an investment's important attributes and assumptions.
   • This ensures that there is no need to find parallels for comparison.
      
3. Helps with scenario building:
   • Investors can tweak the cash flows predicted for different scenarios.
   • It helps them determine what changes the returns go through under different conditions.

The DCF method helps investors figure out an investment’s present value by taking into account its future cash flows. This further helps investors determine the investment required to receive fixed returns. The main basis of the DCF is rooted in the idea of the time value of money.