How do you determine the future value of an investment opportunity? You either need a crystal ball, or you need to know how to perform a discounted cash flow (DCF) analysis.
This article will help you understand the principles of discounted cash flow so that you'll be better equipped to evaluate your investments.
What is discounted cash flow (DCF)?
Discounted cash flow (DCF) is a valuation method that evaluates an investment based on its future cash flows. DCF analysis seeks to determine how much money an investment will make in the future, determining its present value. If the DCF is higher than the current investment cost, it's a clear sign that the investment will yield positive returns.
How do you determine the future cash flows? You'll use the DCF formula, which relies on a discount rate to calculate the final discounted cash flow.
The discounted cash flow model can be applied to investments of every variety, ranging from stocks and securities to alternative investments such as real estate or valuable art.
Keep in mind, however, that the DCF model is based on estimations, not certainties. But even though these estimates might prove inaccurate, DCF analysis is still the surest way to assess an investment's potential value.
Discounted cash flow vs. net present value
DCF analysis is one of several valuation methods you can use together to evaluate a potential investment opportunity. A similar method is known as net present value or NPV. The DCF gives you a picture of how much future cash flows are worth today. The NPV, on the other hand, will evaluate the net return on your investment after accounting for the initial cost.
To calculate the net present value, you'll add one step to the DCF process. You'll deduct your upfront costs from the DCF. This approach will give you a more accurate picture of how your investments impact your company and the return on investment (ROI) for various projects.
If these methods sound similar, it's because they work in tandem to help you make decisions about acquiring assets. Both will evaluate your estimated cash flows and help you assess the wisdom of a purchasing decision.
Why discounted cash flow is important
At its simplest, discounted cash flow (DCF) will help you make decisions about the future value of your investments. Whether you're an individual investor or a larger organization, this assistance is important. Here are just some of the things that DCF analysis can provide:
- DCF helps you account for the time value of money
A DCF analysis helps you evaluate forecasted cash flows based on the time value of money. This understanding means that today's dollar is generally worth more money than a dollar tomorrow since the money today can be invested. DCF will help you account for this difference and recognize the earnings potential of the money you invest.
- DCF provides an objective analysis of future earnings
Discounted cash flow analysis helps you evaluate your expected future cash flows independent of market value and financial performance. Capital markets tend to misprice assets, and the DCF formula can provide an objective, mathematical calculation independent of market factors.
- DCF assists in business acquisitions and mergers
DCF can be particularly helpful when businesses are bought and sold. Few things are more challenging than determining the monetary value of a company.
But DCF can provide a detailed assessment of the company's overall value and projected future cash flow. In the world of investment banking, this helps companies evaluate a firm's cost and determine whether the asking price is a good value.
- DCF helps you make investment decisions
Ultimately, DCF allows you to make wise decisions regarding purchasing stocks or other assets. Discounted cash flow can help investors evaluate expected cash flows and the terminal value of the investment.
This information can help make one-time investments but can also help with capital budgeting and determining whether a particular project is worth the company's time and money.
The discounted cash flow formula
To calculate discounted cash flow, you'll need to use the following formula:
DCF = (CF1)/(1+r)^n
While this is a basic formula, it can be a little intimidating if you're not used to calculating things like cash flow projections. It may help to break down each variable:
- CF1 = free cash flow
- r = the discounted rate
- n = the number of years included in the forecast period
In a real-world discounted cash flow analysis, you'll actually repeat this calculation for each year in your projected time period and add these figures together. This repetition means that the complete DCF formula will look something like this:
DCF = (CF1)/(1+r)^1 + (CF2)/(1+r)^2 + (CFn)/(1+r)^n
Again, each CF value represents the free cash flow for that particular year. Your final equation will have as many individual calculations as the number of years in your time period, described by the variable "n" above.
How to use the discounted cash flow formula
The DCF formula is relatively easy to use once you understand how to calculate each component. Here's how to plug these values into the DCF formula:
Calculate your free cash flow (CF)
Cash flow (CF) represents the net cash flow you receive from an investment, based on variables such as a bond's principal payment or interest rate. The cash flow can also indicate how much money a company has after subtracting payments on investments, operating expenses, and capital expenditures.
Determine your discount rate (r)
When evaluating a business, the discount rate is the firm's Weighted Average Cost of Capital or WACC. A company's WACC is the average rate it expects to pay its stakeholders to finance its assets.
Bonds and other securities are a bit simpler. For other assets, the discount rate is equal to the interest rate on the investment itself. Since you won't know if this rate will change in the future, you'll simply use the rate from the initial investment when performing your calculation.
Plug these values into the DCF formula
Once you have these figures, you'll simply plug them into the DCF formula. Remember, you'll perform this calculation for each year in your time period, which will help you evaluate future cash flows over time.
This step is where using a spreadsheet can be helpful, as it will make it far easier to crunch the numbers and compare discounted cash flows for multiple investment periods.
Evaluate your investment
Once you've calculated your discounted cash flow, you can decide on the prospective investment.
Suppose the DCF value is higher than the present value of the business or asset. In that case, the investment is likely to offer a favorable growth rate and provide a positive return on the initial investment.
On the other hand, if the DCF value is lower than the present value, the investment is unlikely to provide significant financial returns.
What if the discounted cash flow yields the same amount as the asset's present value? While this is unlikely, it means that the investment may simply allow you to break even.
However, remember that the discounted cash flow method estimates an investment asset's future value, so while these calculations provide concrete numbers, they are still not absolute.
Example of discounted cash flow analysis
How might an investment company calculate DCF for an upcoming project? The company would simply apply the formula using the method above.
For example, imagine your company considering investing in a specific project. The project will last three years, with the following projected cash flows each year:
- Year one: $1 million
- Year two: $2 million
- Year three: $3 million
The initial cost of the investment is $2.5 million. Is this project worth it for your company?
To answer this question, imagine that your company's WACC is 5%, which means you'll use 5% as their discount rate.
Plugging these numbers into the DCF formula, you get the following:
DCF = ($1 million)/(1+0.05)^1 + ($2 million)/(1+0.05)^2 + ($3 million)/(1+0.05)^3
If you take it each step at a time, you'll get the following values for each year (rounded to the nearest dollar):
- DCF year 1: $952,381
- DCF year 2: $1,814,059
- DCF year 3: $2,591,513
We get a final value of around $5.36 million by adding these numbers. Since the initial investment was $2.5 million, this project will be well worth the cost of the investment.
The limits of DCF analysis
DCF analysis is a helpful method for evaluating prospective investments and projects. However, this method has significant limitations.
For starters, these values are based on a series of estimates. If the expected cash flows prove inaccurate, this will distort the calculations of the discounted cash flows for each year. In other words, the final discounted cash flow value will only be as reliable as the estimates used to make these calculations.
Additionally, the discount rate is based on interest rates and other valuations that can vary depending on a range of possibilities, such as the condition of the market, the company's growth rate, and the organization's risk profile.
Despite these limits, this method still provides investors with a valuable tool for evaluating potential investment opportunities and can also help determine whether a business's cost reflects the company's true or fair value.
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Frequently asked questions
Here are some of the top questions that investors ask about discounted cash flow:
You can use the DCF formula to assess the intrinsic value of investment opportunities and projects. You might perform an analysis when preparing to:
- Evaluate the cost of an entire company
- Estimate the value of a specific project
- Assess the value of a bond
- Assign a value to shares of stock in a company
- Perform an estimate on an investment property
- Implement a cost-saving initiative within a company
Some financial analyses will need to be performed regularly, such as when evaluating your company's operating cash flow. But you'll only perform discounted cash flow analysis when facing a major financial decision. The DCF formula will guide these decisions or provide data that senior management can use in creating company-wide policies.
The DCF model depends on an investor's ability to know the WACC value or an appropriate discount rate when calculating. But this discount rate can vary considerably, making it hard to pin down.
Additionally, there may be times when this discount rate is not known. This lack of knowledge can occur when you're considering the acquisition of a company. For example, you may not have access to the company's current value to translate this into meaningful data.
Other financial models can help you evaluate your investment opportunities and costs. These include:
- Internal rate of return (IRR)
- Modified internal rate of return (MIRR)
- Net present value (NPV)
You can also use multiple methods to evaluate a project or investment for major decisions. These methods can also be used when you don't know your WACC value or discount rate or if this rate is subject to a lot of variation. However, like DCF, all these methods still rely on the types of estimates that can vary in terms of reliability.