Discounted Cash Flow (DCF): Calculation & Analysis with Examples

If there is one thing certain in the investment world, it is uncertainty you can never be sure of the results. However, there are strategies and financial models that you can use to estimate the return potential of investments. One such valuation method is the Discounted Cash Flow or DCF analysis. This article explores the meaning, calculations, benefits and challenges of DCF analysis. 

What does discounted cash flow mean?

The DCF model focuses on the intrinsic value of an asset. By using a set formula, it estimates the current value of an investment based on its expected future cash flows. The approach revolves around a popular financial concept known as the ‘Time Value of Money’, which holds that the present value of a rupee is worth more than the same amount in the future because it has a return-earning potential. 

Discounted cash flow analysis is widely used to estimate the value of businesses, real estate, stocks, and bonds. If the present value of expected future cash flows exceeds the initial investment cost, the investment is viewed as potentially profitable and vice versa. 

Why is DCF important in valuation?

Discounted cash flow can be a powerful tool for investors. Here’s why: 

1. It helps assess the intrinsic value of an asset

Investments are affected by both internal and external factors. DCF particularly focuses on an asset’s fundamental value based on its expected future cash flows. Knowing the real financial strength and potential of an investment can help investors invest confidently. 

2. It helps understand the risks associated with an asset

Since DCF discounts future cash flows, it accounts for the uncertainty and risk level of an investment. Moreover, a significant portion of DCF comes from the terminal value, which estimates cash flows beyond the initial forecast period. This helps in assessing long-term investment risks.   

3. It is adaptable and flexible 

DCF allows investors to consider different possible scenarios in the investment world by adjusting variables such as revenue growth and discount rates.  For instance, investors can use discounted cash flow analysis to evaluate how an investment might perform during an economic downturn. Such an approach may aid in making strategic investment decisions. 

Key components of DCF analysis 

Below are the five key components that drive the discounted cash flow analysis:

1. Free Cash Flow (FCF): FCF is the foundation of any DCF analysis. It refers to the cash generated by a business after accounting for operating expenses and capital expenditures.
2. Discount rate: This is the rate used to discount or convert future cash flows to present value, reflecting the risk of the asset. 
3. Projection period: This is the number of years for which future cash flows are forecasted, often ranging from five to ten years.
4. Terminal value: This is the estimated value of the investment beyond the projection period. It is usually calculated using the perpetuity or exit multiple method.
5. Present value: Future cash flows are discounted back to arrive at the asset’s present value. 

How to calculate discounted cash flow?

Below is a step-by-step guide to calculating DCF:

Step 1: Estimate the FCF 

The first step is to forecast the FCF based on operating costs, profit margins, and capital expenditure assumptions. This is done for a defined period, typically five to ten years. 

Step 2: Determine the discount rate 

You can use the Weighted Average Cost of Capital (WACC) as the discount rate: 

WACC = (E / V x Re) + [D / V x Rd x (1 - Tc)]

Here, E is the market value of equity, D is the market value of debt, Re is the cost of equity, V is the total market value (E+D), Rd is the cost of debt, and Tc is the corporate tax rate.

Step 3: Calculate the terminal value 

Next, calculate the asset’s terminal value using any of the two methods:

• Perpetuity method

Terminal value = [FCFn (1 + g)] / (r – g), where FCFn is the projected cash flow for the final year, g is the perpetual growth rate, and r is the discount rate.

• Exit multiple method

In this method, the terminal value is calculated by multiplying the financial metric of a company with a trading multiple.

Step 4: Compute the enterprise value 

Discount the estimated FCF and terminal value to the present value to arrive at the enterprise value (EV).

Step 5: Determine the equity value 

Subtract the company’s net debt from EV to determine equity value.

Step 6: Interpret the result 

Compare the DCF valuation with the asset’s market price. If the calculated intrinsic value is higher than the market price, the asset may be undervalued and vice versa.

Note: You can use the discounted cash flow calculator for quick and accurate results. Alternatively, you can use the following formula to compute DCF manually:

[Cash flow for Year 1 / (1 + r)¹] + [Cash flow for Year 2 / (1 + r)²] + [Cash flow for Year 3 / (1 + r)³] + ... + [Cash flow for Year n / (1 + r)ⁿ]

Here, r is the discount rate, and n is the number of years.

Limitations and challenges of DCF analysis 

While DCF is a powerful tool, it has some limitations:

1. It is based on estimates: Overreliance on estimates and assumptions rather than accurate data can be a major drawback of DCF. 
2. It is heavily dependent on TV: A significant portion of the valuation often comes from the terminal value, which can introduce uncertainty.
3. It is not a standalone metric: Since DCF only focuses on the asset’s intrinsic value, it should not be considered in isolation and must be complemented by other valuation methods for better results. 
4. It may not be suitable for short-term investments: The DCF model is better suited for investors with a long investment horizon as short-term cash flows can be volatile and difficult to predict.

Conclusion

The discounted cash flow method remains one of the most widely used valuation techniques in finance. It helps investors understand an investment’s intrinsic value and determine its true value. However, the DCF valuation model does have limitations. Hence, it should be used alongside other valuation methods to ensure well-rounded investment decisions.