What is a discounted cash flow (DCF)?
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis attempts to determine the value of a business today, based on projections of the amount of money it will generate in the future.
The DCF analysis finds the present value of expected future cash flows using a discount rate. An estimate of the present value is then used to assess a potential investment. If the value calculated via DCF is greater than the current cost of the investment, the opportunity should be considered.
The DCF is calculated as follows:
- CF = Cash Flow
- r = discount rate (WACC)
- DCF is also known as the discounted cash flow model
Discounted cash flow (DCF)
Discounted cash flow (DCF) operation
The purpose of the DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes that a dollar today is worth more than a dollar tomorrow.
For example, assuming 5% annual interest, $ 1.00 in a savings account will be worth $ 1.05 per year. Likewise, if a payment of $ 1 is delayed for a year, its current value is $ 0.95 because it cannot be put into your savings account.
For investors, DCF analysis can be a practical tool to confirm the fair value prices published by analysts. It requires you to take into account many factors that affect a business, including future sales growth and profit margins. You will also need to think about the discount rate, which is influenced by the risk-free interest rate, the company’s cost of capital and the potential risks to its share price. All of this helps you better understand the factors that determine share prices, so that you can put a more accurate price on the company’s stocks.
A challenge with the DCF model is to choose the cash flows that will be discounted when the investment is large, complex or the investor cannot access future cash flows. The valuation of a private business would be largely based on the cash flow that will be available to new owners. The DCF analysis based on the dividends paid to minority shareholders (who are available to the investor) for publicly traded stocks will almost always indicate that the stock is of poor value.
However, DCF can be very useful in evaluating individual investments or projects that the investor or company can monitor and predict with reasonable confidence.
DCF analysis also requires a discount rate that takes into account the time value of money (risk-free rate) plus a return on the risk they take. Depending on the purpose of the investment, there are different ways to find the correct discount rate.
An investor could set his DCF discount rate equal to the return he expects from an alternative investment of similar risk. For example, Aaliyah could invest $ 500,000 in a new house which she hopes to be able to sell in 10 years for $ 750,000. Alternatively, she could invest her $ 500,000 in a real estate investment trust (REIT) which is expected to yield 10% per year over the next 10 years.
To simplify the example, we will assume that Aaliyah does not take into account the cost of replacing the rent or the tax effects between the two investments. All she needs for her DCF analysis is the discount rate (10%) and future cash flow ($ 750,000) from the future sale of her home. This DCF analysis has only one cash flow, so the calculation will be easy.
In this example, Aaliyah should not invest in the house, as her DCF analysis shows that her future cash flow is only worth $ 289,157.47 today. Once the tax effects, rent and other factors are included, Aaliyah can see that the DCF is a little closer to the current value of the house. Although this example is overly simplified, it should help illustrate some of the problems with DCF, including finding suitable discount rates and making reliable future forecasts.
Weighted average cost of capital (WACC)
If a company is evaluating a potential project, it can use the weighted average cost of capital (WACC) as the discount rate for estimated future cash flows. The WACC is the average cost that the company pays for borrowing or selling capital.
Imagine a company that could invest $ 50 million in equipment for a project that should generate $ 15 million per year for 4 years. At the end of the project, the equipment that has been used can be sold for $ 12 million. If the company’s WACC is 12%, a DCF analysis can be performed.
In this case, the company must invest in the project because the DCF analysis gives a value greater than the initial investment of $ 50 million.
Limits of the discounted cash flow model
A DCF model is powerful, but there are limits when applied too widely or with the wrong assumptions. For example, the risk-free rate changes over time and may change over the course of a project. Changing the cost of capital or recovery values expected at the end of a project can also invalidate the analysis once a project or investment has already started.
Applying DCF models to complex projects or investments that the investor cannot control is also difficult, if not impossible. For example, imagine an investor who wants to buy shares in Apple Inc. (AAPL) at the end of 2020 and decides to use DCF to decide if the current price is fair value.
This investor must make several assumptions to complete this analysis. If it uses Free Cash Flow (FCF) for the model, should it add an expected growth rate? What is the right discount rate? Are there alternatives or should she just rely on the estimated market risk premium? How long will it hold the shares of AAPL and what will its value be at the end of this period? Unfortunately, there are no consistent answers to these questions, and since she cannot access AAPL’s cash flow as a minority shareholder, the model is not useful.
Summary of Discounted Cash Flow Model (DCF)
Investors can use the concept of present value of money to determine whether the future cash flows of an investment or project are equal to or greater than the value of the initial investment. In order to perform a DCF analysis, an investor must make estimates of future cash flows and the final value of the investment, equipment or other assets.
The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment considered. If the investor cannot access future cash flows or the project is very complex, DCF will not have much value and alternative models should be used.