Discounted Cash Flow
Discounted cash flow (DCF) is a valuation method used for estimating the present value of future cash flows such as capital expenditures and other investments. The said method incorporates the concept of time value of money as it recognizes that receiving $15,000 in cash today is more valuable than receiving payment of $15,000 in the future. Similarly, $15,000 received in year 5 would have less worth than $15,000 received in year 2.
The DCF method incorporates the effect of time value of money basically by discounting the future cash flows back to the time when funds are invested by the entity.
The said method is used for evaluating a potential project or investment. If the net value calculated using the DCF method is higher than the cost of the investment then in such a scenario the proposed opportunity to invest should be considered.
What DCF Tells Its Users?
Analysts use DCF for estimating the sum of money an entity would receive from a specific investment or project after being adjusted for the time value of money. The concept of time value of money is based on the assumption that a Dollar/Pound/Rupee/Dirham/Riyal etc. today has more worth than received in the future because today it can be invested to generate more money. Analysts use DCF analysis wherein a person is making payments in the present with expectations of return on the said payments in the future.
DCF analysis is used for determining the present value of cash flows expected in the future using a discount rate. Investors can make use of the present value of money concept to determine whether the future cash flows expected from a specific project in the future exceeds the project’s initial investment. If the DCF of the project exceeds its initial investment then the entity should consider doing the project.
In order to carry out a DCF analysis, it is important to make estimates regarding future cash flows as well as the value of equipment, investment and other assets at the end of the investment period. It is also important for the entity carrying out the analysis to determine a suitable discount rate to discount the cash flows, which may change depending on various factors such as the conditions of the capital markets and the investing entity’s risk profile. If the investor is unable to determine future cash flows, or the investment project is very complex in nature then DCF will add little to no value and the investing entity should consider alternative models to analyze the project.
Limitations of DCF
The main draw backs of using DCF is that it requires the analyst/investor to make a lot of assumptions. Firstly, the investor would be required to accurately estimate the expected future cash flows from a specific project or investment. The future cash flows usually rely on a number of different factors, such as the status of the economy, market demand, competition, technology and unforeseen opportunities or threats. Selecting a discount rate for the DCF model is also an assumption which the investor would have to make for the model to be worthwhile.
Steps for Calculating DCF
The first step for calculating DCF involves estimating future cash flows from a specific investment. The second step involves selecting a discount rate which is usually equivalent to the financing cost of the investment or the cost of losing out on an opportunity presented by other investments or projects. The final step is to discount the estimated cash flows back to the current date, using a spreadsheet, financial calculator, or a manual calculation.
Example of a DCF Calculation
An entity has an investment opportunity in which it would generate $200 per annum for the next three years. If that entity wants to calculate the present value of the cash flows generated by this opportunity using a 12% discount rate then it would have to reduce the said cash flows by the aforementioned discount rate as worth of the money in the future is less than what it is worth today. Specifically, the cash flow in the first year is worth $178.60 today, the cash flow of the second year is worth $159.40 today, and the cash flow in the third year is worth $142.4 today. Adding up all the cash flows, it can be concluded that DCF of the investment opportunity is $487.4.
Is DCF the Same as Net Present Value (NPV)?
No, the discounted cash flow is not the same as NPV, however the two methods are petty similar. Essentially, the NPV includes another step in the DCF calculation process. The additional step involves deducting the initial investment cost of the project or investment opportunity from the investment’s discounted cash flows. For instance, if the cost of investing in the opportunity mentioned in the above example were $300 then the NPV of the said investment would be $187.4.