Discount Cash Flow analysis or DCF analysis as it is called is a method that is used to assess the present value of a company or its assets.
The valuation is based on the amount of cash flows (read money) it can generate in the future.
Assumptions in DCF
The underlying assumption in DCF is that a company or an asset is expected to make money (generate cash flow) over time.
The second assumption, which is also a fundamental theory, is that value of money today is worth more than it will be tomorrow.
Based on the two principles the method derives its model and also its name – Discounted Cash Flow
- Discounted is adjusting for the diminishing value of money
- Cash Flow is the money generate by a business/asset
Here’s the equation:
Discounted Cash Flow = CF1 / (1+dr)1 + CF2/ (1+dr)2 +…..+ CFn/ (1+dr)n
Let’s break the components in a simpler form –
- Discounted Cash Flow – It is the sum of all future discounted cash flows that an asset/company is expected to produce. This sum is the fair value that we are solving for.
- CF – It is the total cash flow for a given year. CF1 is for the first year, CF2 is for the second year and so on.
- dr – It is the discount rate which is nothing but the target rate of return that you are looking from the investment. It is the weight average cost of capital (WACC).
Let us now see an example.
Assume an individual or a company offered you Rs.15,000 in a three year period and asked how much you are willing to pay for the offer. To answer his question, you are required to calculate what the value of Rs.15000 is today.
What is worth noticing here is that, reaching Rs 15,000 is no big deal in three years time but how much returns you are expecting.
If you are looking for high yields (say 14.47%) and you believe that the asset has the capability of generating this kind of returns, you should only offer Rs 10,000 to the individual A.
Thus, from the example, we see what the DCF equation does. It translates future cash flows that you are likely to receive by investing in an asset to its present value today. This translation is based on the compounded rate of return you could reasonably achieve with your money today.
Application in Real Life
When you are looking to buy shares of a company or buying a business or a real estate asset for that matter, you need to project and discount the expected cash flows.
If you find that an investment that is priced below the sum of discounted cash flows, it depicts undervalued and therefore, a potentially rewarding investment.
On the other hand, if the price is higher than the sum of discounted cash flows, the asset may be overvalued.
When to Use the Application?
The calculation used in DCF make it appropriate for certain types of industries or companies. DCF framework provides an evaluation of a company’s current value by projecting its future free cash flows, or profit.
Thus, it necessitates making an estimation, assumption about business growth, profitability and much more.
In simple words, it is more suited for companies that are larger with relatively steady growth. Remember, projecting growth for smaller-sized companies or any company that is experiencing volatile and rapid growth or is exposed to some degree of seasonality or cyclicality.
Thus, the sectors in which DCF analysis is more useful are utilities, oil and gas, etc. where income, expenditure and growth tend to be relatively stable and steady over time.
What are the pros of DCF analysis?
A DCF model requires a lot of detail to estimate the intrinsic value of a stock. Following are the advantages of the model –
- Incredibly detailed and includes all significant assumptions regarding the business
- It helps determine the “intrinsic” value of a business
- It does not require any comparable companies
- While the model is detailed, it can be built in tools like Excel
- Model is suitable for analyzing mergers and acquisition
- Used to compute the internal rate of return IRR of an investment which is critical for making investing decisions
- Multiple scenarios can be built in the model that allows for sensitivity analysis
- The fundamental drawbacks of the model are that significant time is required to project the variables that are involved.While some parameters such as operating cost and revenue may be easy to anticipate in advance, but getting the right understanding of capital expenditure, other investments and funding mix remain an area of concern.Thus, even a minor deviation in any of the metrics lead to a vast change in the company’s valuation.
- The second drawback is that in DCF we typically project for a ten year period which is a long-term horizon. Thus, getting projections accurate for this long-term horizon is difficult given the volatility and cyclicality in the economy.
Thus, owing to multiple projections that are long-term, the model is prone to errors, and overcomplexity. The outcome of the model is very sensitive to changes in assumptions. Also, it is challenging to estimate the WACC accurately.
Disclaimer: The views expressed in this post are that of the author and not those of Groww