Discounted cash flow (DCF) is a financial analysis technique used to value an investment or a company. It is based on the concept that the value of an investment today is equal to the sum of its future cash flows, discounted at an appropriate rate to reflect the time value of money.
To calculate the present value of future cash flows, we use the following formula:
Where: PV = Present value of cash flows CF1, CF2, … CFn = Cash flows in period 1, 2, … n r = Discount rate
The discount rate is usually the cost of capital or the expected rate of return that an investor requires to invest in the particular investment or company. The cash flows can be estimated by analyzing historical data or making projections based on assumptions about the future performance of the investment or company.
The DCF method is widely used in corporate finance, investment banking, and equity research to value companies, projects, and other investments. It is a powerful tool for making investment decisions and evaluating the feasibility of a particular investment opportunity.
Example of Discounted Cash Flow
Let’s say you are considering investing in a company that has the potential to generate cash flows of $100,000 per year for the next five years. After that, you expect the cash flows to decline by 5% per year. You also assume that the appropriate discount rate for this investment is 10%.
To calculate the present value of these cash flows, we can use the DCF formula:
Where: CF1 = $100,000 r = 10%
Using this formula, we can calculate the present value of each year’s cash flow as follows:
To calculate the present value of the cash flows beyond year 5, we need to use the formula for the present value of a growing perpetuity:
PV = CF / (r – g)
Where: CF = Cash flow in the first year after the growth rate has stabilized r = Discount rate g = Growth rate
In this case, we assume that the cash flows will decline by 5% per year, so the growth rate is -5%. Therefore, the present value of the cash flows beyond year 5 is:
PV = $62,102.08 / (0.1 – (-0.05)) = $1,240,418.52
Adding up the present values of each year’s cash flow, we get the total present value of the investment:
Total PV = $90,909.09 + $82,644.63 + $75,131.41 + $68,301.29 + $62,102.08 + $1,240,418.52 = $1,619,507.02
So, according to this DCF analysis, the investment is worth $1,619,507.02 today, assuming the assumptions about cash flows and discount rate hold true.
Conclusion
The discounted cash flow (DCF) method is a financial analysis technique used to value an investment or a company by calculating the present value of its expected future cash flows, discounted at an appropriate rate to reflect the time value of money. The DCF method is widely used in corporate finance, investment banking, and equity research to make investment decisions and evaluate the feasibility of investment opportunities. In the example provided, we showed how the DCF method can be used to calculate the present value of an investment with expected cash flows and a discount rate assumption. However, it’s important to note that the DCF method relies heavily on the accuracy of assumptions and projections, and changes in those assumptions can significantly impact the resulting valuation.
Also read: What is Net Present Value (NPV) and How Can It Help in Investment Decisions?
