What is discounted cash flow analysis?
DCF analysis is an intrinsic valuation method that is used to estimate the value of an investment based on the cash flows that are expected to be generated by it. When looking at dividends, earnings, operating cash flow or free cash flow, it establishes a rate of return or discount rate. This rate of return or discount rate is then used to determine the value of the business independent of other market considerations.
More specifically, it attempts to address the question, "How much money will I receive from this investment over a period of time, and how does that compare to the amount I could earn through other investments?"
Specifically, it does so by taking into account the time value of money, which assumes that a dollar invested today is worth more than a dollar invested tomorrow because the money is earning interest over a longer period of time.
Key Components of Discounted Cash Flow
Free cash flow (FCF) –It is cash generated by the assets of the business (tangible and intangible) that is made available for distribution to all sources of capital in the business. Due to the fact that it reflects cash flow that is available to all sources of capital, free cash flow is also referred to as unlevered free cash flow. It is unaffected by the capital structure of the business.
Terminal value (TV) – Value at the end of the FCF projection period (horizon period).
Discount rate – The rate used to discount projected FCFs and terminal value to their present values.
Discounted Cash Flow Formula
It is equal to the sum of the cash flows in each period divided by one plus the weighted average cost of capital (WACC) raised to the power of the period number, which is the discounted cash flow (DCF) formula.
Here is the DCF formula:
DCF = CF1 / (1+r)1 + CF2/ (1+r)2 +…..+ CFn/ (1+r)n
(CF=Cash Flow) - Cash Flow (CF) represents the net cash payments an investor receives in a given period for owning a given security (bonds, shares, etc.)
When building a financial model of a company, the CF is typically what’s known as unlevered free cash flow. When valuing a bond, the CF would be interest and or principal payments.
(r=The discount rate) - For the purpose of business valuation, the discount rate is typically equal to a firm's Weighted Average Cost of Capital (WACC). WACC is used by investors because it represents the required rate of return that they expect from their investment in a company, according to the company.
It is assumed that the discount rate on a bond is equal to the interest rate on that particular security.
(n = Period Number) - Each cash flow is associated with a specific time period of operation. Years, quarters, and months are all common time periods to use. It is possible that the time periods will be equal, or that they will be different. If they are not the same, the percentages are expressed as a percentage of a year.
What are the uses of DCF
The goal of DCF analysis is to estimate the amount of money that an investor would receive from a particular investment after taking into account the time value of money. The time value of money hypothesis assumes that a dollar today is worth more than a dollar tomorrow because it can be invested for a future return. Therefore, a DCF analysis is appropriate in any situation where a person is paying money now with the expectation of receiving more money later on in the future.
The DCF Formula can be applied in a variety of situations.
To determine the worth of a company as a whole
To determine the worth of a project or investment within a company
In order to determine the value of a bond
In order to determine the value of a company's stock,
In order to determine the worth of an income-producing property
In order to determine the value of a cost-savings initiative at a company,
To determine the worth of anything that generates (or has an impact on) cash flow
Pros and Cons of DCF
The DCF is, theoretically, arguably the most sound method of valuing a company or asset.
The DCF method is forward-looking, and it is more reliant on future expectations than it is on past results.
The DCF method is more inward-looking, relying on the fundamental expectations of the business or asset, and is influenced to a lesser extent by volatile external factors than the other methods discussed here.
The DCF analysis is focused on cash flow generation and is less affected by accounting practices and assumptions than other types of financial analysis.
The DCF method allows for the consideration of expected (and different) operating strategies in the valuation process.
The DCF analysis also allows for the valuation of different components of a business or synergies on an individual basis.
The DCF is, theoretically, the most sound method of valuing a business.
As a forward-looking method, the DCF method is more reliant on future expectations than on past results.
Unlike other valuation methods, the DCF method is more inward-looking, relying on fundamental expectations of the business or asset, and is influenced to a lesser extent by volatile external factors.
The DCF analysis is focused on cash flow generation and is less influenced by accounting practices and assumptions than other types of analysis are.
This method incorporates anticipated (as well as different) operating strategies into the valuation process.
Different components of a business or synergies can be valued separately using the DCF analysis method as well.
Steps to conduct discounted cash flow analysis
A number of assumptions must be made in order to conduct a DCF analysis, including the company's forecasted sales growth and profit margins (its cash flow), as well as the rate of interest paid on the company's initial investment, the cost of capital, and potential risks to the underlying value of the company (aka discounted rate). The more insight you have into a company's financials, the easier it is to complete the task.
With so many variables, it's easy to see why pricing a deal can be difficult, and why most investors and transaction advisors choose to use multiple types of valuation models to inform their decision-making, in addition to DCF analysis, to ensure that they get the best deal possible. An accurate response can assist in determining how much an investment is currently worth and which deals are worth walking away from in the current market.
Essentially, the DCF model assumes that the value of a business is solely a function of the cash flows it generates in the future. As a result, the first challenge in developing a DCF model is defining and calculating the cash flows generated by a company. In order to calculate the cash flows generated by a company's operations, there are two commonly used approaches.
Unlevered DCF approach
Forecasting and discounting the operating cash flows are important tasks. In order to arrive at a present value, first add any non-operating assets such as cash and subtract any financing-related liabilities such as debt until you arrive at a present value.
Levered DCF approach
The cash flows that remain available to equity shareholders after all non-equity claims (i.e. debt) have been removed are forecasted and discounted using the discounted cash flow method.
Both should theoretically result in the same value at the end (though it is actually quite difficult to get them to be exactly equal in practice). Due to its popularity, the unlevered DCF approach is the primary focus of this guide.
1. Project a company's Free Cash Flows
To forecast cash flows generated by a company's core operations after accounting for all operating expenses and investments, the first step is to estimate the cash flows generated by the company's core operations. The term "unlevered free cash flows" refers to these cash flows that have not been leveraged.
FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures
Capital expenditures its- represent cash investments the company must make in order to sustain the forecast growth of the business. If you don’t factor in the cost of required reinvestment into the business, you will overstate the value of the company by giving it credit for EBIT growth without accounting for the investments required to achieve it.
2. Calculate the company's Terminal Value
It is impossible to forecast cash flows indefinitely. Eventually, you will need to make some high-level assumptions about cash flows that will extend beyond the final explicit forecast year, which will require estimating a lump-sum value for the business that will extend beyond the explicit forecast period. The "terminal value" is the lump sum that represents the end of a project. The terminal value (TV) of a DCF represents the value that the company will generate from all of the expected free cash flows after the explicit forecast period.
3. Discounting the cash flows to the present at the weighted average cost of capital (WACC)
The weighted average cost of capital refers to the discount rate that reflects the riskiness of the unlevered free cash flows over the long term. In addition, because unlevered free cash flows represent all operating cash flows, these cash flows are considered to "belong" to both the company's lenders and its owners. As a result, the risks associated with both sources of capital must be taken into account through the use of appropriate capital structure weights (hence the term "weighted average" cost of capital). The enterprise value is the present value of all future unlevered free cash flows after they have been discounted.
4. Add the value of non-operating assets to the present value of unlevered free cash flows
To determine the present value of unlevered free cash flows in the case of a company with any non-operating assets, such as cash or investments that are simply sitting on its balance sheet, we must first calculate the present value of all of the company's operating assets.
5. Subtract debt and other non-equity claims
DCF's ultimate goal is to obtain what is legally theirs, which is their equity ownership (equity value). As a result, if a company has any lenders (or any other non-equity claims against the business), we must deduct this amount from the present value of the company's assets. What's left over is the property of the equity investors.
A common practice is to combine non-operating assets and debt claims into a single term known as net debt (debt and other non-equity claims – non-operating assets). The following equation is frequently encountered: enterprise value – net debt = equity value. After the DCF generates an equity value, it can be compared to the market capitalization (which represents the market's perception of the equity value).
6. Divide the equity value by the shares outstanding
The equity value tells us what the total value to owners is. But what is the value of each share? In order to calculate this, we divide the equity value by the company’s diluted shares outstanding.
Frequently Asked Question (FAQ)
What is Discounted Cash Flow (DCF)?
Discounted Cash Flow (DCF) is a financial valuation method used to estimate the value of an investment based on its expected future cash flows. It calculates the present value of these cash flows by discounting them using an appropriate discount rate, typically the cost of capital or the investor's required rate of return.
How does DCF work?
DCF works by projecting the future cash flows expected to be generated by an investment and then discounting those cash flows back to their present value. The basic idea is that money received in the future is worth less than the same amount of money received today, due to factors such as inflation and the time value of money.
What are the key components of DCF analysis?
The key components of DCF analysis are the projected cash flows, the discount rate, and the terminal value. Projected cash flows represent the expected future cash inflows and outflows associated with the investment. The discount rate is used to calculate the present value of these cash flows, reflecting the risk and opportunity cost of the investment. The terminal value represents the value of the investment beyond the projection period.
What is the discount rate in DCF analysis?
The discount rate in DCF analysis represents the rate of return required by an investor to undertake the investment. It is often determined by the investor's cost of capital, which includes the risk-free rate of return and a risk premium to compensate for the investment's specific risks. The discount rate reflects the time value of money and accounts for the fact that future cash flows are less certain than present cash flows.
How are cash flows projected in DCF analysis?
Cash flows are projected by forecasting the expected future revenue and expenses associated with the investment. This typically involves estimating sales or revenue growth rates, profit margins, capital expenditures, working capital requirements, and taxes. Cash flow projections should be based on realistic assumptions and consider factors such as market conditions, competition, and industry trends.
What is the terminal value in DCF analysis?
The terminal value in DCF analysis represents the value of an investment beyond the projected cash flow period. Since it's often impractical to forecast cash flows indefinitely, the terminal value is calculated by assuming a perpetuity or a stable growth rate. Common methods for calculating terminal value include the Gordon Growth Model, the exit multiple approach, or the liquidation value approach.
What are the limitations of DCF analysis?
DCF analysis has certain limitations. It relies heavily on the accuracy of cash flow projections and the discount rate assumptions. It is also sensitive to changes in key variables, such as revenue growth rates and discount rates. Additionally, DCF analysis assumes that cash flows can be reinvested at the discount rate, which may not always be realistic.
When is DCF analysis commonly used?
DCF analysis is commonly used for investment valuation, including valuing stocks, bonds, real estate, and businesses. It is also used for project evaluation and capital budgeting decisions, such as assessing the profitability of potential investments and determining whether to proceed with a project.
How does DCF analysis compare to other valuation methods?
DCF analysis is considered a fundamental valuation method, focusing on the intrinsic value of an investment based on its expected cash flows. It takes into account the time value of money and provides a framework for evaluating investments over a long-term horizon. Other valuation methods, such as relative valuation or market-based approaches, rely on comparing the investment to similar assets or market multiples.
Are there any alternative methods to DCF analysis?
Yes, there are alternative methods to DCF analysis, such as the payback period, internal rate of return (IRR), and net present value (NPV). These methods have their own strengths and weaknesses. The payback period focuses on the time it takes to recoup the initial investment, while IRR calculates the rate of return that makes the net present value of an investment zero. NPV compares the present value of cash inflows to the present value of cash outflows, providing a measure of profitability. While these methods can be useful, DCF analysis is often preferred for its ability to capture the long-term value of an investment.
How does risk affect DCF analysis?
Risk plays a crucial role in DCF analysis. A higher level of risk associated with an investment will increase the required rate of return or discount rate, resulting in a lower present value of future cash flows. Conversely, lower risk investments will have lower discount rates, leading to higher present values. Risk assessment involves considering factors such as industry volatility, market conditions, competition, and specific risks associated with the investment project.
Can DCF analysis be used for any type of investment?
DCF analysis can be used for various types of investments, including stocks, bonds, real estate properties, and businesses. However, it is important to note that DCF analysis is most suitable for investments with predictable cash flows and a longer time horizon. Investments with uncertain or highly volatile cash flows may require additional risk assessment and adjustment of discount rates.
What is sensitivity analysis in DCF?
Sensitivity analysis is a technique used in DCF analysis to assess the impact of changes in key variables on the estimated value of an investment. By varying assumptions, such as growth rates, discount rates, or terminal values, sensitivity analysis helps identify the most critical factors affecting the investment's value. It provides insights into the robustness of the valuation and assists in understanding the potential risks and uncertainties involved.
How accurate is DCF analysis?
The accuracy of DCF analysis depends on the quality of the underlying assumptions and the availability of reliable data. Since DCF analysis involves forecasting future cash flows, it inherently carries some degree of uncertainty. It is essential to base projections on realistic assumptions, conduct thorough research, and update the analysis as new information becomes available. DCF analysis is most valuable as a tool for assessing relative value comparisons and making informed investment decisions, rather than providing precise numerical outcomes.
Can DCF analysis be used for short-term investments?
DCF analysis is typically used for long-term investments due to its focus on projecting and discounting future cash flows. Short-term investments with limited cash flow visibility may not be suitable for DCF analysis. In such cases, other methods like the payback period or simple return on investment (ROI) calculations may be more appropriate for evaluating short-term profitability.