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Discounted Cash Flow

Discounted cash flow or DCF is the method for estimating the current value of an investment by taking into account its future cash flows. It can be used to determine the estimated investment required to be made in order to receive predetermined returns.

The discounted cash flow method is based on the concept of the time value of money, which says that the money that an individual has now is worth more than the same amount in the future.

For example, Rs.1,000 will be worth more currently than 1 year later owing to interest accrual and inflation. If a person is seeking to invest Rs.1,000 now, he or she will want to know its return on investment and what its future valuation will be, which can be calculated through DCF.

What is DCF?

DCF stands for Discounted Cash Flow. This is a business valuation method that allows you to assess the current value of a company and/or its assets.

In other words, discounted cash flow is when a company’s free cash flow is discounted back to today’s value. Breaking down everything into bits and pieces to explain it in a lucid way.

What is Cash Flow?

Cash Flow is the money generated by the company that is available to be reinvested in the business or distributed to investors.

What is Free Cash Flow?

Free Cash Flow or Unlevered Free Cash Flow is the cash left over after the company deducts operating expenses and CapEx (capital expenditures). This cash flow is available to both debt and equity investors.

As an investor, this is an important metric in evaluating the value of a company because net revenue and accounting profit do not offer a clear picture of the economic value of a company.

What is Discounted Cash Flow?

With a clear understanding of Cash Flow and Free Cash Flow, let’s look at what is Discounted Cash Flow?

Discounted Cash Flow is a method of calculating the present value of a company (or even an investment) based on the projected cash flow in the future. DCF valuation is based on the concept of the time value of money.

Time Value of Money

A Rupee today is worth more than a Rupee tomorrow because you can invest it and earn more money on it.

The DCF method of finding the value of an investment or a company can be used by anyone who is paying money today with the expectation of receiving higher returns in the future. Hence, there are two assumptions that form the foundation of discounted cash flow techniques:

  • As time passes, a company or an asset will make money.
  • Time Value of Money

Therefore, in simple words, to calculate the present value of a company/asset, you need to adjust for the diminishing value of money. This is Discounted Cash Flow.

Where can the Discounted Cash Flow Method be Used?

DCF can be used to estimate the valuation of –

  • A business
  • Real estate
  • Stocks
  • Bonds
  • Long-term assets
  • Equipment

What is the Formula for Calculating DCF?

The DCF formula is as follows –

In this formula –

Cash flow Includes the inflows and outflows of funds.

For bonds, the cash flows are principal and dividend payments.

Cash flow in the DCF formula is sometimes denoted as CF1 (cash flow for 1st year), CF2 (cash flow for 2nd year), and so on.

r Denotes the discount rate.

For businesses, it is the weighted average cost of capital (WACC). It is the rate which investors expect to receive on average from a firm for financing its assets. WACC includes the average cost of a firm’s working capital minus taxes.

In the case of a bond, the discount rate is the rate of interest.

n Denotes the final or additional years.

DCF method can be used for projecting long-term valuation, which can extend up to a decade or even more.

Example – 

Let’s assume that Mr. Shankar plans to make an investment of Rs.1 Lakh in business for a tenure of 5 years. The WACC of this business is 6%.

The estimated cash flows are mentioned below – 

Year Cash flow
1 Rs.20,000
2 Rs.23,000
3 Rs.30,000
4 Rs.37,000
5 Rs.45,000

Based on the formula –

Therefore, the DCF for each year will be – 

Year Cash flow Discounted cash flow
1 Rs.20,000 Rs.18,868
2 Rs.23,000 Rs.20,470
3 Rs.30,000 Rs.25,188
4 Rs.37,000 Rs.29,307
5 Rs.45,000 Rs.33,627

The total discounted cash flow valuation will be Rs.1,27,460. When subtracted from the initial investment of Rs.1 lakh, the net present value (NPV) will be Rs.27,460. As the NPV is a positive number, Mr. Shankar’s investment in the businesses will be lucrative. 

However, if he had invested Rs.2 Lakh, he would have incurred a loss of Rs.72,540 as the NPV would have been negative. 

Calculating the Weighted Average Cost of Capital (WACC)

It may so happen that investors have to calculate the weighted average cost of capital (WACC) before finding DCF.

In such cases, they can use the following formula –

WACC = (E / V x Re) + [D / V x Rd x (1 – Tc)]

In this formula,

E Market value of a business’ equity.
D Market value of the business’ debt.
Re Cost of equity
V Total market value of the business’ financing. (E + D)
Rd Cost of debt
Tc Rate of corporate tax

Example – 

Company ABC has shareholder equity of Rs.50 Lakh (E), and its long-term debt was Rs.10 Lakh (D) for the fiscal year 2019. Therefore, the total market value of ABC’s financing is Rs.60 Lakh (V = E + D).

Now, let’s assume that the cost of equity (Re) and the cost of debt (Rd) of ABC is 6.6% and 6.4%, respectively. The rate of corporate tax is 15%.

Using the formula – 

WACC = (50 / 60 x 6.6%) + [10 / 60 x 6.4% x (1 + 15%)]

= 0.055 + (0.167 x 0.065 x 1.15)

= 0.055 + 0.012

= 0.067

Therefore, WACC = 6.7%, which shareholders of ABC are receiving on an average every year for financing its assets. 

What is the Terminal Value in DCF?

The terminal value in DCF analysis is the final causation at the end of the formula. It is the projected growth rate of cash flows for the years over and above the considered period.

There are two methods for calculating the terminal value –

  • Exit multiple methods –In this method, a financial metric of a company (like EBITDA) is multiplied by a trading multiple (for e.g. Terminal value = EBITDA x 10).
  • Perpetuity method – Terminal value = [FCWnx (1 + g)] / (WACC – g).Here, FCF is free cash flow and ‘g’ is the perpetual growth rate of FCF.

As projections in DCF in case of business go as far as 5 or 10 years, making a reliable estimate after that period can become challenging. Hence, the terminal value is used to forecast cash flow after that particular time frame.

How can DCF help investors?

As an investor, you can use DCF valuation in the following scenarios:

If you are planning to buy a business, real estate property, or invest in shares and want to project and discount the expected cash flows, you can use the DCF method.

If the investment is priced below the sum of the discounted cash flows, then it can be taken as an indicator of an undervalued investment. This makes it a potentially rewarding investment. However, if it is priced higher than the sum of the discounted cash flows, then the investment might be overvalued.

The DCF method is appropriate for larger companies with steady growth. Avoid using this method for smaller companies or any company that is experiencing volatile or rapid growth. Also, avoid using it for companies that are exposed to seasonality or cyclicality. Some sectors where DCF analysis can prove useful are oil, gas, utilities, etc. where growth is stable over time.

Pros & Cons using DCF analysis

Benefits

Here are some advantages of using the DCF model for assessing the value of a company/investment:

  • Helps calculate the intrinsic value of a company
  • You don’t need data of peer companies to estimate the value of the target company
  • DCF can be calculated in Excel. You don’t need any additional tools.
  • For investments, this method can be used to calculate the Internal Rate of Return (IRR) to help you make investing decisions.
  • It can be a handy tool during mergers and acquisitions

Downsides

Here are some disadvantages of using DEC valuation:

  • The time and effort required to project various parameters like operating cost, revenue, CapEx, investments, etc. A small deviation in any of these values can result in a huge change in the valuation of the company.
  • Typically, the DCF method is used to project for a period of around ten years. Getting accurate projections for such a long tenure can be difficult especially since the Indian economy is volatile and cyclical.

These cons make the DCF model prone to errors. Also, estimating the WACC accurately can be a challenge. Given the sensitivity of the model to changes in assumptions, using this model effectively requires a lot of factors to be accurate.

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