An introduction to discounted cash flow (DCF)
There are many variations of cash flow in different contexts across financial modelling. Discounted cash flow (DCF) is one of these. DCF is a financial modelling technique used to estimate the value of an investment or business based on its expected future cash flows. DCF analysis is widely used in financial analysis because it helps investors make informed decisions about potential investments. In this blog post, we will provide an overview of DCF and explain how it works.
What is discounted cash flow?
In essence, DCF analysis involves estimating the future cash flows of an investment, discounting them back to their present value using a discount rate, and then summing up the present values to arrive at a fair value estimate. The formula below helps to highlight this.
The discounted cash flow formula
The formula for DCF is as follows:
DCF = (CF1 / (1 + r)^1) + (CF2 / (1 + r)^2) + … + (CFn / (1 + r)^n)
Above you can see where DCF is the discounted cash flow, CF1 through CFn are the expected cash flows in years 1 through n, while r is the discount rate, and n is the number of years.
What are the advantages of using DCF
DCF has several advantages over other valuation methods, such as the ability to account for the time value of money, the flexibility to incorporate changes in future cash flows and discount rates, and the ability to provide a quantitative measure of the value of an investment. DCF analysis can also help investors make better investment decisions by providing a clear understanding of the potential risks and returns associated with an investment.
Are there limitations of using DCF
Where there are advantages, you can expect to find a few limitations. For example, DCF analysis relies heavily on the assumptions and inputs used to estimate future cash flows and discount rates. The accuracy of the DCF analysis depends on the quality of these inputs. Alongside this, DCF analysis may not be appropriate for all types of investments, such as those with unpredictable or highly volatile cash flows.
How to use discounted cash flow
To use DCF, you need to follow several steps.
- First, estimate the expected cash flows for the investment.
- Next, determine an appropriate discount rate to use based on the risk associated with the investment.
- Then, calculate the present value of each cash flow by dividing it by the appropriate discount factor.
- Finally, sum up the present values to arrive at the fair value estimate for the investment.
A discounted cash flow example
Let’s say you’re considering investing in a new business venture. You have estimated that the business will generate $100,000 in cash flow each year for the next five years, and you want to know what the business is worth today based on those future cash flows.
To calculate the value of those future cash flows, you’ll need to use a discount rate. Let’s say you decide to use a discount rate of 10% per year, to account for the time value of money and the risk involved in the investment.
Using the DCF formula, the present value of the cash flows for each year would be:
- Year 1: $90,909 (i.e., $100,000 / (1 + 10%))
- Year 2: $82,644 (i.e., $100,000 / (1 + 10%)^2)
- Year 3: $75,131 (i.e., $100,000 / (1 + 10%)^3)
- Year 4: $68,301 (i.e., $100,000 / (1 + 10%)^4)
- Year 5: $62,092 (i.e., $100,000 / (1 + 10%)^5)
To calculate the total present value of the cash flows, you would add up these individual present values:
$90,909 + $82,644 + $75,131 + $68,301 + $62,092 = $379,077
Therefore, based on all of the above assumptions, the business would be worth $379,077 today, using a discount rate of 10% and assuming $100,000 in cash flow for the next five years.
Is it worth using DCF?
DCF is a powerful tool for estimating the value of an investment based on its expected future cash flows. By understanding the advantages and limitations of DCF and following the appropriate steps, investors can use DCF to make informed investment decisions. While DCF analysis may not be appropriate for all types of investments, it remains a widely used and effective valuation method in finance and accounting.
Thanks to the many features provided, a financial modelling tool can automate many of the calculations involved in DCF analysis, saving time and reducing the risk of errors. It can also provide visualizations and reports to help you better understand the results of your analysis and communicate them to others. Ultimately, using a financial forecasting tool like Brixx can help you make more informed investment decisions by providing a rigorous and data-driven approach to evaluating investment opportunities.
