What is Discounted Cash Flow (DCF)?
Discounted cash flow (DCF) is an analysis method used to value investment by discounting the estimated future cash flows. DCF analysis can be applied to value a stock, company, project, and many other assets or activities, and thus is widely used in both the investment industry and corporate finance management.
- Discounted cash flow (DCF) evaluates investment by discounting the estimated future cash flows.
- A project or investment is profitable if its DCF is higher than the initial cost.
- Future cash flows, the terminal value, and the discount rate should be reasonably estimated to conduct a DCF analysis.
Understanding DCF Analysis
DCF analysis estimates the value of return that investment generates after adjusting for the time value of money. It can be applied to any projects or investments that are expected to generate future cash flows.
The DCF is often compared with the initial investment. If the DCF is greater than the present cost, the investment is profitable. The higher the DCF, the greater return the investment generates. If the DCF is lower than the present cost, investors should rather hold the cash.
The first step in conducting a DCF analysis is to estimate the future cash flows for a specific time period, as well as the terminal value of the investment. The period of estimation can be your investment horizon. A future cash flow might be negative if additional investment is required for that period.
Then, you need to determine the appropriate rate to discount the cash flows to a present value. The cost of capital is usually used as the discount rate, which can be very different for different projects or investments. If a project is financed through both debt and equity, the weighted-average cost of capital (WACC) approach can apply.
Calculation of Discounted Cash Flow (DCF)
DCF analysis takes into consideration the time value of money in a compounding setting. After forecasting the future cash flows and determining the discount rate, DCF can be calculated through the formula below:
The CFn value should include both the estimated cash flow of that period and the terminal value. The formula is very similar to the calculation of net present value (NPV), which sums up the present value of each future cash flow. The only difference is that the initial investment is not deducted in DCF.
Here is an example for better understanding. A company requires a $150,000 initial investment for a project that is expected to generate cash inflows for the next five years. It will generate $10,000 in the first two years, $15,000 in the third year, $25,000 in the fourth year, and $20,000 with a terminal value of $100,000 in the fifth year. Assuming the cost of capital is 5%, and no further investment is required during the term, the DCF of the project can be calculated as below:
Without considering the time value of money, this project will create a total cash return of $180,000 after five years, higher than the initial investment, which seems to be profitable. However, after discounting the cash flow of each period, the present value of the return is only $146,142, lower than the initial investment of $150,000. It suggests the company should not invest in the project.
Pros and Cons of Discounted Cash Flow (DCF)
One of the major advantages of DCF is that it can be applied to a wide variety of companies, projects, and many other investments, as long as their future cash flows can be estimated.
Also, DCF tells the intrinsic value of an investment, which reflects the necessary assumptions and characteristics of the investment. Thus, there is no need to look for peers for comparison.
Investors can also create different scenarios and adjust the estimated cash flows for each scenario to analyze how their returns will change under different conditions.
On the other hand, the use of DCF comes with a few limitations. It is very sensitive to the estimation of the cash flows, terminal value, and discount rate. A large amount of assumptions needs to be made to forecast future performance.
DCF analysis of a company is often based on the three-statement model. If the future cash flows of a project cannot be reasonably estimated, its DCF is less reliable.
Innovative projects and growth companies are some examples where the DCF approach might not apply. Instead, other valuation models can be used, such as comparable analysis and precedent transactions.
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