- 03 Sep 2021
- Bonds
- Business
- Comments: 0
Discounted cash flow is a method of valuation business people use to estimate the value of their businesses based on their expected future cash flows.
In other words, it helps business people determine the value of their business today depending on projections of the money it will produce in the future (future cash flows).
Discounted cash flows help people make decisions like company acquisitions, investing in securities or companies, buying stocks, and investing in technology startups.
It also helps managers and business owners who want to make operating expenditure and capital budgeting decisions like leasing or buying new equipment or opening new company branches and factories.
How Does Discounted Cash Flow Work?
People use discounted cash flow analysis to approximate the amount of money they will get from an investment or business adjusted for the money’s time value. Time value of money projects that a dollar now is worth more than the same dollar tomorrow since people can invest it.
Therefore, it is appropriate for people to conduct discounted cash flow analysis in situations where they are paying money today expecting to get more money tomorrow.
Assuming, for example, you save $1 in your savings account with an annual interest rate of 5%. Its value in a year will be $1.05.
In the same way, if someone delays paying your $1 for a year, the present value of that dollar is 95 cents since you can't take it to your savings account for it to earn interest.
Discounted cash flow analysis determines the future value of cash flows expected in the future using discount rates.
Therefore, business people can use this analysis to determine if the future cash flow of their current projects or investments is less than, equal to, or greater than the value of their initial investments.
Suppose you are an investor using discounted cash flow analysis, and you find that the value you get after using the formula is greater than what you are currently investing. In that case, you should consider that project or investment.
To conduct your discounted cash flow analysis, you need to estimate the future cash flows of the investments and their ending value. You also need to do the same for the equipment and any other assets you will acquire for the venture.
You must also come up with a suitable discount rate for your discounted cash flow model. The discount rate you choose can differ depending on your project or investment, for example, the capital market's conditions and your risk profile.
If your project is too complex of you can’t access future cash flows, conducting a discounted cash flow analysis will not be of much help, and you should consider another approach.
Formula For Discounted Cash Flows, DCF= CF1 1 1 +r +CF2 21+r + CFn n1+r; Where:
CF is the cash flow for each year. CF1 being the cash flow for the first year, and CF2 is the cash flow for the second year. CFn is the cash flow for any additional years.
Cash flow is the net amount of money you get after a given period of being in the investment or starting a business.
If you have a company and are creating its financial model, the cash flow is what you refer to as the unlevered free cash flow. However, if you are investing in a bond, the cash flow is the interest or principal payments.
R is the discount rate. To evaluate your business, the discount rate is normally its weighted average cost of capital. Business people use WACC since it is a representation of the needed rate of return expected from the investment.
If you are dealing with bonds, the discount rate is the interest rate mentioned for the security.
N is the period number. These represent the period after which you expect the above cash flow to come in. Mostly, they are normally the same. However, if you use different ones, you express them as year percentages.
An Example Of A Discounted Cash Flow
As mentioned above, companies use their weighted average cost of capital as their discount rate. Therefore, if you want to invest in a new venture and the WACC of your company is 5%, that will be the discount rate you use when calculating the discounted cash flow.
Let’s use an example where you have an initial investment of $13 million for a project you expect to last for five years, and your expected cash flows are as follows:
Year | Cash flow |
---|---|
1 | |
2 | $2 million |
3 | $3 million |
4 | $4 million |
5 | $5 million |
Using the 5% discount rate for your company, the discounted cash flows of your company’s investment will be as follows:
Year | Cash flow | Discounted cash flows to the nearest $ |
---|---|---|
1 | $1 million | $952,381 |
2 | $2 million | $1,814,059 |
3 | $3 million | $1,903,251 |
4 | $4 million | $3,290,810 |
5 | $5 million | $3,917,631 |
The summation of all the discounted cash flows is $11,878,132. If you subtract your initial investment of $10 million, you get an NPV (Net Present Value) of $1,121,868.
Since that is a positive number, the cost of your investment today is worthwhile since the investment will give you positive discounted cash flows. If your initial investment was $15 million, the NPV would have been -$1, 693,272, showing that the investment would not have been worthwhile.
Is Discounted Cash Flow And Net Present Value The Same?
NPV and DCF are two closely related valuation methods, but they are different. NPV adds another step to the DCF analysis calculation.
After getting the sum of the discounted cash flow of your investment, the NPV method requires that you subtract your initial investment from the sum of your discounted cash flows.
Advantage Of Using Discounted Rate Of Return
1. It Is a Detailed Method
Discounted cash flow analysis method uses numbers that cover important assumptions about your business, including its growth rate, weighted average cost of capital, and cash flow projections to come to get the net present value.
2. Objectivity
This method gives you the intrinsic value of your business or investment because it does not consider subjective market factors like depreciation.
3. You Do Not Need to Compare
Unlike other valuation methods, you do not have to compare your company to other similar companies to understand how it is going to perform.
4. Considers Long-time Investment Values
One of the things that makes this method more superior to others is that it assesses the earnings of your business or investments over its full economic life.
5. Gives You a Chance to Compare
Using the discounted cash flow valuation analysis, you can compare different companies and investment opportunities and decide which one is the best depending on the highest value.
6. Easy to Understand
Unlike other valuation methods, it is easy for you to understand how to use the discounted cash flow method of valuation because it has a simple formula.
It is also easy for you to understand the results without much interpretation or explanation because it uses a single value. You can also work out the value in excel, which makes it faster and more reliable.
7. Relies on Free Cash Flows
Using free cash flows is a reliable way to determine the value of your investment. That is because it eliminates all subjective accounting policies plus window dressings that come in reported earnings.
It does not matter whether people categorize cash outlay as an operating expense or an asset in the balance sheet. Free cash flow shows the true amount left over for you as an investor.
8. Allows You to Incorporate Major Changes in the Business or Investment Venture
You could change the amount of your initial investment of the discount rate, things you would not have had a chance to do if you were using other valuation methods.
9. You Can Use It as a Sanity Check
Before you invest in a company, you can use discounted cash flow method to determine if the company's stock is undervalued or over-valued and by how much. That lets you know if the current price of the stocks or securities you want to buy is justified.
It also allows you to know how changes in the assumption of your business or investment will affect the final value of your calculation. Some of the assumptions subject to change include the discount rate and growth of the cash flows.
10. It Is a Perfect Way to Analyze Mergers and Acquisitions
Mergers and acquisitions are some of the most important decisions companies have to make. They could be responsible for the success or failure of your company.
If you have identified a company you would like to acquire or merge with your company, you can calculate their future value using discounted cash flows. That way, you are sure that the company will not go down and bring yours along.
11. You Can Use It to Calculate the Internal Rate of Return
The internal rate of return is described as the rate at which a present investment will yield returns, and you can calculate that using the discounted cash flows.
Disadvantages
1. Requires You to Make Many Assumptions, Which Makes It Prone to Errors
In as much as the method allows you to understand the intrinsic value of a business or investment venture and lets you compare, you need to make many assumptions.
You have to estimate the future cash flows of each period your business will operate, and you have to do that correctly or make them as close as possible to the actual cash flow. That is sometimes difficult because the cash flow of your business or investment depends on factors like competition, technology, unforeseen opportunities and threats, and market demand.
One of the main problems with this is that you may estimate very high cash flows, which could make you choose a business or investment that will not pay off in the long run, hurting your profits.
You could also end up making very low cash flow estimations, which will lead you to think that an investment is costly, causing you to miss an opportunity that would pay off later. You also need to choose the correct discount rate to make the business or investment worthwhile.
2. You Need to Be Alert for Changes and Modifications
Discounted cash flow is ever-changing because of the changes in the market. If the company you are investing in changes, or there comes up changes with your investment, it could change the cash flows you expected for a certain period, and it requires you to go back to the drawing board.
3. It Is Not Perfect for Estimating the Value of Short-term Investments
While it is perfect if you are looking at a long-term business or investment venture, it is impossible to estimate the value of a business you want to operate for the short term.
4. Requires You to Have a Lot of Data
For the calculations to be accurate, you need to have significant financial data, including cash flow projections plus capital expenditure over a few years.
You also need to have a history of the cash flow trends in the sector you want to invest in to allow you to project. Lack of that data could lead you to make the wrong assumptions.
Anytime you want to conduct a valuation for your company or investments, you must consult financial professionals. You also need to consult economic analysts. They will help you understand some finical aspects of the business that you would have overlooked.
They also advise you on some of the internal and external factors that could affect your business and mess with your estimated figures.