Guide to discounted cash flow
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Investors typically use discounted cash flow to calculate the potential value of an investment based on its future cash flows. However, discounted cash flow is also beneficial for business owners who want to measure their business’ financial performance and its potential value to outside investors.
In this article, we’ll discuss the definition of discounted cash flow, the benefits and downsides of using this particular valuation method, when it’s appropriate to use, and how to calculate it for your organization.
What is discounted cash flow?
Discounted cash flow (DCF) is a unique valuation method that calculates the current value of a business or investment based on its future cash flows.
The output from a discounted cash flow expresses the valuation in today’s dollars based on expected income in the coming months or years.
Investors often use discounted cash flow to determine whether a business is worth purchasing or if an investment will provide certain desired returns.
As a valuation method, it’s essential to remember that the output from the calculation is only as accurate as the projections or forecasts used. A poorly projected forecast of expected future cash flows can result in a valuation that is wildly different from its true worth.
Discounted cash flow formula
The discounted cash flow formula is relatively simple to use. The formula appears below:
The discount rate for the discounted cash flow formula usually equals the company’s weighted average cost of capital (WACC) rate. The WACC rate represents the cost of debt or the typical interest rate for borrowing money.
An investor may use the expected rate of return for the investment as the discount rate.
Finally, the terminal value represents the final sales price of an investment or business. The terminal value is an estimate based on several years in the future.
How to calculate discounted cash flow
Let’s consider an example to calculate the value of a business using the DCF formula.
The company prepares a forecast showing the following cash flows for the next five years:
The company’s WACC is 10% and has a terminal value of $500,000.
To calculate the total value of the discounted cash flow, we’ll insert the values into the DCF formula.
DCF = $4,437,013.74
Let’s assume the business owner receives an offer to purchase the company for $3M. If the business owner accepts the offer, it will result in a positive return for the investor. However, the business owner will lose a significant portion of the company's actual value.
If the same investor offers $4.5M to purchase the company, they’ll be able to recover most of their investment, but it may result in a negative return of ($62,986.26).
The first offer is favorable to the investor, while the second is beneficial to the business owner.
Business owners should fully evaluate their company before entertaining options to sell it to potential investors.
Advantages of a discounted cash flow analysis
Performing a discounted cash flow analysis takes time but benefits business owners and investors. A comprehensive DCF model will involve multiple calculations of forecasted cash flows for a specific period. The cash flow projections should include all expected inflows and outflows.
A few advantages of the discounted cash flow analysis include the following:
A good discounted cash flow will include a thorough assessment of expected cash inflows and outflows, with strict attention to detail. The financial model should account for customer and product or service revenues and incorporate expected yearly expenses.
The discounted cash flow should clarify the methodology and assumptions to ensure that investors and business owners understand how the analyst derived expected cash flows and discount rates.
Identifies the intrinsic value of the business
A discounted cash flow calculates the organization's or investment's objective value using expected inflows or outflows. The financial model ignores market sentiment when arriving at the valuation.
Doesn’t require a comparison of other investments or businesses
There’s no external research needed when calculating the discounted cash flow. All the variables are available through the organization’s existing contracts, expenses, and other assumptions.
If an investor uses discounted cash flow to determine an investment's value, it relies strictly on projections. There is no comparison of the valuation against other stocks of a similar nature.
Valuation for the long-term
The discounted cash flow model is appropriate to determine the long-term value of a company. You can estimate cash flows for years to come and apply an appropriate discount rate to account for the time value of money.
Provides a means for objective comparison
While you don’t need to involve comparables when performing a DCF analysis, you can use the result to compare multiple investment opportunities. For instance, an investor evaluating several companies for purchase can use the valuation models to determine which one best fits their return requirements.
Similarly, investors considering various stock purchases can use the DCF analysis to determine the approximate return on their investment and pick the appropriate purchase.
The DCF method is also appropriate for evaluating investments of different types. For instance, if the investor is considering purchasing a company, a commercial real estate property, and an oil well, they could objectively compare the valuation results for all three potential purchases.
Doesn’t require advanced financial modeling software
A business owner or investor can perform a DCF analysis using simple spreadsheet software like Excel. You don’t need to purchase complex financial modeling software to do the analysis.
Suitable for evaluating mergers and acquisitions
The discounted cash flow method is appropriate for evaluating complex mergers and acquisitions. While its helpful to employ other valuation tools for mergers and acquisitions, too, the DCF analysis serves as an objective tool for decision-making.
Allows for a complete sensitivity analysis
You can easily adjust the cash flows for various assumptions to determine how sensitive the valuation is to specific changes. It’s also possible to adjust the discount rate and cash flow growth to account for variations.
Disadvantages of a discounted cash flow analysis
Like every valuation model in corporate finance, there are drawbacks to the discounted cash flow method. A few of the most significant disadvantages include the following:
Takes time to gather data
A discounted cash flow analysis relies on large amounts of data, including projected revenues, expenses, and planned capital expenditures. Depending on the size of the business, projecting cash flows for extended periods may require significant effort from the financial planning and analysis team or other analysts.
In some cases, gathering data for certain investments may prove next to impossible. Suppose there is no history of a potential investment’s performance and little evidence of future revenues. In that case, the results from the valuation model may be markedly different from the actual outcome.
Highly sensitive to future projections
A discounted cash flow analysis is very sensitive to forecasts and projections. The results will be misleading if it doesn’t account for all of the inputs and outputs. Analysts must carefully consider all elements of the analysis, including the cash flow growth rate, the discount rate, and the components of each year’s cash flow.
Analysts should include a sensitivity analysis to adjust for factors that can dramatically impact the valuation of the investment or business.
Dependent on accurate estimates
There’s an old saying prevalent among financial gurus: “Garbage in, garbage out.” Essentially, the statement means that poor estimations will result in an inaccurate final calculation.
The discounted cash flow is only as accurate as the quality of its cash flow projections and predetermined growth rate. If there are a lot of unknown factors or significant risks of changes in cash flows from one year to the next, the results from the valuation will be inaccurate.
Might be overly complex to calculate
The discounted cash flow formula, which is simple to interpret, can grow overly complex for large organizations with many elements that affect yearly cash flows.
The discounted cash flow model provides the most accurate valuation results for small business owners who don’t have lots of potential variation in their future cash flows.
Challenging to determine the terminal value
The discounted cash flow model's terminal value represents the final amount for which an investment can sell. Since the terminal value is often a number based far in the future, estimating it can be challenging.
The terminal value can make up a significant portion of the results of the valuation model, so business owners must give it the attention it is properly due.
Difficulties determining WACC
A company’s weighted average cost of capital isn’t always clear-cut. There may be various discount rates applicable if a business has multiple sources of capital. Business owners will need to determine the most appropriate WACC rate based on their primary sources of financing.
Doesn’t consider the valuations of competitors
While calculating the discounted cash flow with internal metrics can be a significant advantage to companies that don’t have access to their competitor’s financials, it also presents challenges.
Businesses competing in the same markets may have valuations that are highly different from one another, even though they have similar projected income and cash flows.
Varying valuations can result from different assumptions between organizations or outside market factors that analysts don’t include in the DCF valuation.
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Performing a discounted cash flow valuation starts with understanding your future cash flows. You’ll need to analyze expected inflows and outflows for a specified period, typically five to ten years.
Once you’ve established your cash flows, you’ll determine your organization's or investment's terminal value. The terminal value represents the future value of selling your business or investment.
Finally, you’ll determine the WACC, or discount rate. The discount rate represents your organization’s typical cost of capital.
Once you have the appropriate figures, you’ll apply the DCF formula to arrive at your valuation.
The fundamental assumptions of a discounted cash flow model include your expected company revenues and expenses for a given period, the terminal value, and the discount rate. Changes to your key assumptions can result in a significantly different valuation amount.
You’ll want to ensure you feel confident in your future cash flows and discount rate. Performing a sensitivity analysis can identify how changes to your assumptions will impact your organization’s valuation.
Discounted cash flow and net present value contain similar elements, like future cash flows and a discount rate. The main difference between the calculations is that NPV includes startup costs or initial investment to purchase an asset.
Both calculations can incorporate terminal value to determine an organization's or investment's present worth.