The Complete Guide to Discounted Cash Flow

Discounted cash flow is a method of valuing a business or investment by analyzing its expected future cash flows and adjusting them for the time value of money. This approach helps investors and business owners make informed decisions about investments and acquisitions.

The time value of money is a key concept in discounted cash flow, which states that a dollar today is worth more than a dollar in the future. This is because a dollar today can be invested to earn interest, increasing its value over time.

As we'll explore further, discounted cash flow involves estimating a business's future cash flows, determining their present value, and comparing it to the initial investment. By doing so, investors can determine the true value of a business or investment.

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Discounted cash flow, or DCF, is a valuation technique that estimates the present fair value of an investment by using expected future cash flows and a discount rate.

The time value of money, or TVM, is a key concept behind DCF, and it's based on the idea that money today is worth more than money tomorrow.

TVM is a pillar concept of modern finance, and it's used to calculate the present value of future cash flows.

DCF analysis is a useful technique to evaluate any investment that requires a present day cash outlay in exchange for future earnings, making it a valuable tool for investors and businesses alike.

By considering the present value of expected future cash flows, DCF helps investors make informed decisions about whether to invest in a particular opportunity.

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Building a DCF model is a straightforward process that requires you to forecast a company's future cash flows and discount them to the present. The DCF approach requires that we forecast a company's future cash flows and discount them to the present to arrive at a present value for the company.

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There are two common approaches to calculating the cash flows that a business generates: the unlevered DCF approach and the levered DCF approach. The unlevered DCF approach is the most common and is thus the focus of this guide.

To build a DCF model, you need to define and calculate the cash flows that a business generates. This involves forecasting all the line items, which should ideally come from a 3-statement model. A 3-statement model dynamically links all the components together, ensuring that changes in assumptions of one component correctly impact the other components.

The 6-step framework for building a DCF model involves:

You can use a Google Sheet, Excel spreadsheet, or an online discounted cash flow calculator to compute discounted cash flow. The discounted cash flow formula uses a cash flow forecast for future years, discounted back to the equivalent value if received in today's dollars, then sums the discounted value for every year projected.

Here's a simple example of the discounted cash flow formula:

For another approach, see: Shareholder Value Formula

DCF = CF1 + CF2 + … + CFn

Where CF1 is cash flows for year 1, CF2 is cash flows for year 2, and CFn is cash flows for the final year being considered in the DCF financial analysis.

The discount factor (discount rate) in the denominator is 1+ a risk rate adjusted above the risk-free cost of capital, the rate of return expected from other competing investments, or the company's weighted average cost of capital (WACC).

Calculating FCFs is a crucial step in the discounted cash flow process. You can calculate FCF using the formula FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures.

To calculate EBIT, you need to know the company's GAAP-based operating profit. The tax rate is usually a company's historical effective tax rate. D&A stands for depreciation and amortization, while NWC represents annual changes in net working capital.

Here are the key components of the FCF formula:

These components are interrelated, which is why forecasting all line items should ideally come from a 3-statement model. This model dynamically links all components together, ensuring that changes in assumptions of one component correctly impact the other components.

Calculating Unlevered Free Cash Flows (FCF) is a crucial step in determining a company's financial health. It's a measure of a company's ability to generate cash from its core operations after accounting for all operating expenses and investments.

FCF is calculated using the formula: FCF = EBIT x (1- tax rate) + D&A + NWC – Capital expenditures. This formula takes into account a company's Earnings Before Interest and Taxes (EBIT), tax rate, Depreciation and Amortization (D&A), changes in Net Working Capital (NWC), and Capital Expenditures (CAPEX).

A company's tax rate is a critical component of the FCF calculation, and it's typically based on the company's historical effective tax rate. If you're forecasting taxes, using a company's historical effective tax rate is a good starting point.

To calculate FCF, you'll also need to consider a company's D&A, which represents the non-cash expenses related to the depreciation of assets. Additionally, changes in NWC can have a significant impact on FCF, as increases in NWC are cash outflows while decreases are cash inflows.

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Here are the key components of the FCF formula:

By understanding these components and how they impact FCF, you'll be better equipped to make informed decisions about a company's financial health and potential for growth.

Calculating the terminal value is a crucial step in determining the value of a company. It's the estimated lump sum of cash flows beyond the final explicit forecast year.

You can't keep forecasting cash flows forever, so at some point, you must make high-level assumptions about cash flows beyond the final explicit forecast year. This is where the terminal value comes in.

There are two common approaches to estimate the terminal value: Growth in Perpetuity and Exit EBITDA Multiple Method. The Growth in Perpetuity approach uses the formula: Terminal Value = Final forecast CF x (1+g)(r−g), where g is the constant growth rate of the cash flows in perpetuity and r is the discount rate.

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The terminal value can be calculated using valuation multiples or a growing perpetuity. The growing perpetuity approach is often used in DCF models.

Here are the two common approaches to estimate the terminal value:

The terminal value is an estimate of the value the company will generate from all the expected free cash flows after the explicit forecast period.

The discount rate is a critical component of a discounted cash flow (DCF) model, and it's essential to choose the right one to get accurate results.

The Weighted Average Cost of Capital (WACC) is a common discount rate used in DCF models, representing the company's average cost of capital. It takes into account the required return of both equity and debt investors.

However, WACC should only be used if the cash flows included in the DCF model are unlevered, meaning they're available to both debt and equity investors. If the model includes levered free cash flows, the cost of equity must be used as the discount rate.

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The choice of discount rate can have a significant impact on the valuation of a company, making it a critical decision for analysts and investors.

Care must be taken in determining the discount rate to be used within a DCF model, as DCF valuations are highly sensitive to their input assumptions.

Here are some common discount rates used in different settings:

In academia, alternative methods of discounting, such as hyperbolic discounting, are studied to reflect intuitive decision-making, but are not generally used in industry.

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The Net Present Value (NPV) calculation is a key part of the discounted cash flow (DCF) process. It's used to determine the present value of a company's future cash flows.

To calculate NPV, you need to subtract the initial cost from the sum of the present value of the cash flows. This is shown in Example 6, where the NPV calculation is:

Net Present Value = – $150,000 + ($208,328 + $212,182 + $216,112 + $220,114 + $224,205)

The initial cost is subtracted because it represents the upfront investment in year 0. This is a key difference between NPV and DCF, as shown in Example 5.

The NPV calculation can be complex, but it's essential to get it right. As shown in Example 6, the NPV is calculated as:

Net Present Value = – $150,000 + $1,080,941

Net Present Value = $930,941

This means that the present value of the company's future cash flows is $930,941.

Here's a summary of the NPV calculation:

Note that the initial cost is subtracted in year 0, and the present value of the cash flows is calculated for each subsequent year.

The Discounted Cash Flow (DCF) model is a widely accepted method for valuing companies and making investment decisions. It's a rigorous method that takes into account a company's ability to generate cash flow in the future for its shareholders.

WACC, or Working Average Cost of Capital, is a key component of the DCF model. It's calculated by taking all the components that make up working capital and proportionately weighting them to arrive at an average cost of capital.

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M&A teams use DCF as one method to determine the value of a business, alongside other methods such as setting the enterprise value using company comparables for other recent deals in the industry.

The DCF model is used widely in practice as well as in academia, and is a basis for investment and transaction pricing. Business owners and managers can make capital budgeting or operating expenditure decisions based on DCF modeling.

A company's valuation is a function of its ability to generate cash flow in the future for its shareholders, not a function of arbitrary supply and demand for that company's stock.

Investors use DCF as one method of analyzing potential stock investments and their estimated market value. They can also determine the intrinsic value of a stock or a company valuation based on the present value of future dividends with a perpetual growth rate by using the Gordon Growth Model (GGM).

The growth in perpetuity approach assumes a company's UFCFs will grow at some constant growth rate assumption from a certain year to … forever. The formula for calculating the present value of a cash flow growing at a constant growth rate in perpetuity is called the “Growth in perpetuity formula”.

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Discounted cash flow (DCF) analysis is a powerful tool for investors, but it's not without its limitations. A great deal of care should go into identifying the appropriate discount rate, as investors will often use the required rate of return in conjunction with market conditions.

The DCF model's main limitation is that it requires many assumptions, and it's only as good as those assumptions. Investors need to accurately estimate future cash flows, which rely on a high number of factors, including market demand, competitive advantage, economic conditions, technological change, and geopolitical considerations.

A forecast cash flow that's overly optimistic can lead to bad investment decisions, while an estimate that's too low can make a company look expensive and cost an investor an attractive investment opportunity. The discount rate, which represents the required rate of return on the investment, can also significantly impact the results.

Possible cash flow impacts affecting forecast accuracy include:

It's essential to choose an appropriate discount rate and to test your assumptions through DCF sense checks to improve your model.

The DCF model's main limitation is that it requires many assumptions and is only as good as those assumptions. This means that if your assumptions are wrong, your entire model will be wrong.

Accurately estimating future cash flows is crucial, but it's not easy. It relies on a high number of factors, including market demand, competitive advantage, economic conditions, technological change, and geopolitical considerations.

Unforeseen threats and opportunities can have a significant impact on your projections, making it essential to test your assumptions and improve your model through DCF sense checks.

A forecast cash flow that's overly optimistic can lead to bad investment decisions. On the other hand, an estimate that's too low can make a company look expensive and cost an investor an attractive investment opportunity.

Choosing an appropriate discount rate is also vital, as it represents the required rate of return on the investment. The higher the discount rate, the lower the present value will be.

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Constraints of financial forecasting can be a major challenge. The use of estimates in discounted cash flow (DCF) analysis can lead to inaccurate forecasting of future cash flows.

External and internal factors can significantly impact cash flows, making it difficult to predict with certainty. Economic recessions, inflation rate increases, and unanticipated effects of interest rate hikes can all affect cash flows.

Geopolitical events, new competitors entering the market, and changes in sales forecast, cost estimates, and cash conversion cycle can also impact forecast accuracy.

Here are some possible cash flow impacts affecting forecast accuracy:

Using the wrong risk rate, also known as the discount rate, can also affect the discounted cash flow calculation. This can lead to inaccurate investment evaluations, resulting in missed opportunities or underperforming investments.

Investors often use the required rate of return in conjunction with market conditions to determine a suitable discount rate.

A great deal of care should go into identifying the appropriate discount rate, as it's a crucial component of DCF analysis.

A blended discount rate might be used in certain cases to reflect various scenarios, taking into account different market conditions.

The present value formula is a key concept in the DCF approach, and it's used to calculate the value of a company's future cash flows. We can express it as PV = FV / (1 + r)^t, where PV is the present value, FV is the future value, r is the discount rate, and t is the time period.

The discount rate, or r, is usually the weighted average cost of capital, or WACC. It's a crucial component of the DCF formula.

To calculate present value, you can use the PV function in Excel. This is especially helpful when cash flows are different each year, as you'll need to discount each cash flow separately.

The forecast cash flows, or CF, are typically forecasted for a specific period, usually 5 or 10 years. This period is often referred to as the explicit forecast period.

The terminal value represents the value of the company at the end of the explicit forecast period. It's used to calculate the value of all cash flows after that period.

Time period, or t, is usually a year end, but it can be shorter periods like half years or months if more detail is needed.