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.
In this article
Where can the Discounted Cash Flow Method be Used?
DCF can be used to estimate the valuation of –
- A business
- Real estate
- Long-term assets
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 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 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.
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 –
Based on the formula –
Therefore, the DCF for each year will be –
|Year||Cash flow||Discounted cash flow|
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|
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
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.