What is a 'Discounted Cash Flow (DCF)' and how do the Calculations Work?
A discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them to arrive at a present value estimate, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
In simple terms; future predicted incomes and drawing backwards to figure out what a current value is. While the calculations involved are complex, the purpose of DCF analysis is simply to estimate the money an investor would receive from an investment, adjusted for the time value of money.
DCF is also known as the Discounted Cash Flows Model.
So what does that formula mean? Let’s break it down.
The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. For example, assuming 5% annual interest, $1.00 in a savings account will be worth $1.05 in a year. How DCF works in this example: we must consider $1.05 a year from now to be worth $1.00 today. When it comes to assessing the future value of investments, it is common to use the weighted average cost of capital (WACC) (This will be a separate article) as the discount rate.
For a hypothetical Company X, we would apply DCF analysis by first estimating the firm's future cash flow growth. We would start by determining the company's trailing twelve month (ttm) free cash flow (FCF), equal to that period's operating cash flow minus capital expenditures.
Say that Company X's ttm FCF is 50 Milllion. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. It is also important to consider the source of this growth. Are sales increasing? Are costs declining? These factors will inform assessments of the growth rate's sustainability.
Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you may apply a long-term cash flow growth rate, representing an assumption of annual growth from that point on.
For this example, we will say that Company X's is 3%. You will then calculate a WACC; say it comes out to 8%. The terminal value, or long-term valuation the company's growth approaches, is calculated using the Gordon Growth Model (Another whole article):
Terminal value = projected cash flow for final year (1 + long-term growth rate) / (discount rate - long-term growth rate)
Now you can estimate the cash flow for each period, including the terminal value:
Year 1 = 50 * 1.10 55
Year 2 = 55 * 1.10 60.5
Year 3 = 60.5 * 1.05 63.53
Year 4 = 63.53 * 1.05 66.70
Year 5 = 66.70 * 1.05 70.04
Terminal value = 70.04 (1.03) / (0.08 - 0.03) 1,442.75
Finally, to calculate Company X's discounted cash flow, you add each of these projected cash flows, adjusting them for present value using the WACC:
DCFCompany X = (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) + (70.04 / 1.085) + (1,442.75 / 1.085) = 1231.83
Have I lost you? And this is the easy version! Feel free to ask me more and I’m happy to go into detail.
$1.23 billion is our estimate of Company X's present enterprise value. If the company has net debt, this needs to be subtracted. The result is an estimate of the company's fair equity value. If our estimate is higher than the current asking price, we might consider Company X a good investment.
Discounted cash flow models are powerful, but they are only as good as their imports. The key is the effectiveness of the information going into the equation. Small changes in inputs can result in large changes in the estimated value of a company, and every assumption has the potential to erode the estimate's accuracy.