Discounted Cash Flow (DCF)

Implementing discounted cash flow analysis can be a valuable step for businesses to evaluate an investment. Now what is discounted cash flow? If you want to learn more about DCF, welcome to this all-encompassing post.

What Is Discounted Cash Flow (DCF)?

What is Discounted cash flow? Discounted cash flow is the valuation method of estimating the investment’s value using the expected future cash flows. Discounted cash flow valuation model assesses an establishment’s present value. It adjusts the future cash flows to the time value of money.

Discounted cash flow analysis also determines the fair value of projects, assets, or companies by addressing capital cost, risks, and inflation. By doing so, it analyzes the future performance of the company. It assists managers and business owners in making well-informed decisions for operating expenditures or capital budgeting.

The prime objective of Discounted cash flow analysis is to assess the money that any investor receives from the investment. Note that it should be adjusted for the time value of money. Now, what is the time value of money?

In simple language, the time value of money anticipates that an amount you have today might be worth more in future if you invest it. So, the Discounted cash flow analysis is valuable when an individual pays money in the present with an expectation of getting more in the future. Get more details about Trial Balance in accounting.

What is the Discounted Cash Flow Formula?

The discounted cash flow formula includes the following:

Discounted cash flow = (1+r) 1CF1​​ + (1+r) 2CF2​ ​+ (1+r) nCFn

• CF1 is the cash flow for the first year 
• CF2 is the cash flow for the second year
• CFn is the cash flow for the nth year
• r is the discount rate

Components of the Discounted cash flow

To get an insightful analysis of the discounted cash flow components, please note down the following points:

• Cash Flow (CF): CF is the first component that represents the cash payments for owning a security like a share or bond, which the investor receives in a specified period of time

• Discount Rate (r): R for building valuation is the WACC or Weighted Average Cost of Capital (the discount rate is equal to the security’s interest rate for a particular bond)

• Period Number (n): The common time periods are months, quarters, or even years

Read More: Financial Accounting vs Management Accounting

Advantages of Discounted Cash Flow

Discounted cash flow offers the following advantages:

• Intricate: Uses specified numbers which include assumptions about businesses, such as growth rate, cash flow projections, and other measures
• Assesses the Business’s “Intrinsic” Value: Calculates value and is more objective than any other method
• No Use of Comparables: Discounted cash flow analysis doesn’t involve market value comparisons
• Objective Comparison: The analysis allows for analyzing varying types of investments or companies, thereby arriving at an objective & consistent valuation
• Long-Term Values: Assesses an investment or project’s earnings over the economic life

5 Disadvantages of Discounted Cash Flow

The following points assess the limitations of discounted cash flow:

• Needs significant data, such as data on the projected revenue as well as expenses
• The analysis is sensitive to variables, including projections of the future cash flow and perpetual growth rate of an investment
• The analysis depends on accurate estimations, meaning its benefits stay within the boundaries of estimates and projections that it uses
• Based on high confidence in any future cash flow
• Might become extremely complex

Learn about SAP Accounting best practices from the link.

7 Steps of Discounted Cash Flow Valuation Model

It is imperative to perform Discounted cash flow in a comprehensive manner. Follow the given steps for the analysis:

Step 1: Determine the forecasting period and project the financial statements. The forecasting period is based on the firm’s stages, including stable growth rate, high growth rate, perpetuity growth rate, etc.

Step 2: The next step is to calculate the free cash flow to the company. Here, you need to calculate FCFF for the coming five years.

Step 3: The next step is to calculate the discount rate. You need to find the cost of equity, the cost of debt and finally get the WACC result.

Step 4: Now is the right time to calculate the terminal value. The terminal value is the projected cash flow of the final year x (1+ Infinite Growth Rate) / (Discount Rate – Long Term Cash Flow Growth Rate)

Step 5: The next step is to present the value calculations. Find the values for free cash flows to the company & terminal values. You need to use the XNPV formula and NPV formula.

Step 6: The next step in the discounted cash flow analysis is adjusting the enterprise valuation.

Step 7: Finally, it is time to calculate the sensitivity analysis of the output. Here, you need to test the discounted cash flow model with changes. The most significant beliefs having major impacts on the valuation include the following changes:

• Infinite growth rate
• The capital’s weighted average cost

Know the Difference Between Cost Accounting and Management Accounting

How to Conduct Discounted Cash Flow Analysis?

You need to undertake the above-mentioned steps to conduct the discounted cash flow analysis. To compile them, the steps include the following points:

• Project the financial statements
• Compute or calculate free cash flow to the company
• Determine the rate of discount
• Calculate the overall terminal value
• Perform the present value calculations
• Make the adjustments accordingly
• perform sensitivity analysis

Know the Difference Between Cost Accounting and Financial Accounting

The Best Example of Discounted Cash Flow

Here’s narrating a few best examples of discounted cash flow:

• Helps value the whole Business
• Valuing an investment or project within an establishment
• Valuing a bond or shares in that company
• To value the property responsible for producing income
• Values the benefits of the cost-saving initiative at the establishment

In short, it values all things that produce cash flow.

Conclusion

So, this comprehensive post has outlined what Discounted cash flow is, its benefits, the steps of the Discounted cash flow valuation model, and examples. In a nutshell, discounted cash flow analysis allows calculating an establishment’s value today depending on the future cash flow.