Discounted Cash Flow (DCF) is a system of value measurement used to weigh the value of an investment. This is done by analyzing the estimated future cash flow. It is vital to analyze the profitability of investments since it is necessary for business administration. This is because businesses will make decisions based on the analytic information available to them.
The analysis will involve the current value of the investment, its former value, and projected income. In this article, we aim to analyze and calculate the value of the future income coming from such investments, otherwise known as the Discounted Cash Flow.
How Does DCF Work?
Where an investor is looking to put his money down on a company or security, he will rely on DCF analysis to make a decision. Most businesses rely on DCF analysis when they are about to make a major capital expenditure during the course of business. In essence, DCF analysis works in business situations where a person remits money with the hopes of receiving more money in the future.
The major ideology behind Discounted Cash Flow is the belief that money earned today has more buying power than money earned in the future. This is why the analyst will adjust the projected earnings to the monetary time value. The discount rate is another important variable in the formula. The application of a discount rate shows the rate at which money must be invested to yield projected cash flow at specific return rates.
What Is a Cash Flow?
Cash Flow refers to the inflow and outflow of money. From a macroeconomic point of view, it is the movement of money in a specific currency from a central bank account to another. On a lower scale, cash flow refers to the flow of income and expenditures in and out of a business. Cash Flow as an analytic variable gives information on these financial measures:
- Rate of Return for businesses, acquired assets, and venture projects
- Liquidity/Profitability ratio, as not all forms of liquidity, lead to profit. Cash Flow is used to tell the difference between harmful liquidity and helpful liquidity
- Income evaluation, so that the nature of the income earned can be ascertained. If there are many non-cash items in the analysis of income, then the income quality is considered low.
Why Is the Cash Flow Discounted?
As a rule of thumb, cash flow is discounted to know the worth of future with relation to the present. As we have seen earlier, cash in hand today is worth more than the same amount in the future.
Take, for example, you’re investing $10,000 into a business that is projected to yield $2,500 annually for four years. Monetary Time Value shows that the buying power of the amount generated decreases year after year. In that case, discounting the projected cash flow will show you how much the projected income is worth in the present. In basic terms, you will find out how much $2,500 a year from now is worth today.
Why Is DCF Important?
DCF analysis can be both beneficial and unhelpful. It depends on the business context where it is being used. It is important to note that you shouldn’t apply DCF analysis if you do not have an accurate knowledge of the variables. This means that your assumptions must be accurate, or close to accuracy. If your assumptions of the value attached to the variables are not correct, then you will be better off doing something else.
Here are some reasons why Discounted Cash Flow Analysis is important:
- It factors in probabilities for your business in the future
- When done right, it estimates the real value of a business or asset
- You can add as many contextual scenarios as you want. DCF analysis can accommodate them all
- If you’re looking to acquire a new business, this is the best system for accurate business valuation
- Due to its reliance on free cash flow, it is the most trustworthy valuation system. This is because Free Cash Flow is a given, which eliminates ambiguous estimation
When Is the DCF Model Used?
The systemic computation involved in a DCF analysis is suitable for some industries and sectors. It is a pointer to the growth rate of a business, its liquidity, profitability, and any other material information.
The DCF model is suitable for companies and businesses operating on a large scale. Companies like these rarely experience unpredictable fortunes or volatility. The steady, systemic nature of large-scale businesses makes them the best users of the DCF analytic system.
If your business has income, expenditure, and growth which is steady over time, then DCF analysis is a perfect fit. Some sectors in which it can function properly are:
- Oil and Gas Industries
- Utility Companies
- Manufacturing Companies
- Service-based Companies
Example of Discounted Cash Flow
You’re putting in $30,000 into a business, and you’re projected to earn $5,000 every year for six years. At this point, we already know that we’ll calculate the discounted cash flow every year for six years. When we calculate the discounted interest, we will also see the worth of $5,000 as the future value of an investment. In the next section, we shall apply the formula for Discounted Cash Flow for easier understanding.
What Is the Discounted Cash Flow Formula?
To find the Discounted Cash Flow, you must apply the Discounted Cash Flow Formula. It is expressed mathematically in this manner:
C= Cash Flow for the nth year
r = Discount rate
n= The year of the cash flow under projection.
In this scenario, we can assign a random discount rate of 3.15%. However, in real-life applications, it is important to assign rates that align with your rate of return on investment.
In the example above, the annual yield is $5,000 yearly for six years. Let’s calculate the Discounted Cash Flow for all the six years under review.
For the six years we will have the following:
- 5,000/(1+ .0315)^1= $4,847.3
- 5,000/(1+.0315)^2 = $4,699.3
- 5,000/(1+.0315)^3 = $4,555.8
- 5,000/(1+.0315)^4 = $4,416.6
- 5,000/(1+.0315)^5 = $4,281.5
- 5,000/(1+.0315)^6 = $4,150.8
Total = $26,951.3
What this means is that if you invested $30,000, your income over time would be $26,951.3. This follows the belief that the same amount of money diminishes in buying power over time.
What Does the Discounted Cash Flow Tell Us?
In the process of reviewing a prospective investment opportunity, look at the monetary time value and your expected rate of return. The most important thing to look out for is the Return – DCF ratio.
It is also called DCF value. This shows you if you’re better off investing somewhere else, or if you should go ahead with the instant investment opportunity. There are two types of DCF value results. They are High DCF Value and Low DCF value. We shall look at them in some detail.
High DCF Value
Where an investment has a High DCF value, it means that the return is higher than the amount you’re planning to invest. This means that the rate of return is higher than the discount rate. If this is the case, then it is perfectly logical for you to invest your money.
Low DCF Value
If an investment has Low DCF value, it means that the amount you are investing in is higher than the DCF value. As such, the discount rate is higher than the rate of return. If this is the case, we advise that you do not go ahead with your planned investment. If you look at the above example, the DCF value of $26,951.3 is less than the $30,000 which is the original investment. So the investor in the example above should not invest.
How To Build a Cash Flow Forecast in a DCF Model
In simple terms, a DCF model is a business valuation tool that forecasts a company’s unlevered cash flow. This cash flow is then discounted to the Net Present Value (NPV). A cash flow forecast is built on a 3 statement financial model which links all financial statements.
The first step in building a cash flow forecast is to forecast revenue. This involves making projections based on the income the company generates from its main operations. Investment analysts forecast revenue is after accounting for all investments and instant expenditure. The revenue being forecasted is called unlevered free cash flow.
Mathematically it is expressed this way:
FCF = EBIT × (1- tax rate) + D&A + NWC – CE
EBIT = Earnings Before Interest, and Taxes
D&A = Depreciation and Amortization
NWC = Annual Changes in Net Working Capital
CE = Capital Expenditure
To forecast expenses, you should take cognizance of the cost drivers. These are variables that need to be established to allow for an expenditure forecast. This way, you can accurately forecast expenditure within a certain financial period.
Forecasting Capital Assets & Working Capital
Working Capital is the result when you subtract current liabilities from current assets. It is the measure of the company’s liquidity. In forecasting Working Capital, the forecast drivers play a major role in causing change.
Forecasted revenue increase means that there will be extra investments in working capital. A forecasted decrease in working capital means that a company or business is experiencing a market downturn. A growing negative working capital balance means there is no more cash flow. As a result, it is important to analyze and forecast carefully and accurately.
In cases where the free cash flow will continue infinitely, it becomes necessary to add a terminal value. The terminal value represents the steady influx of cash within the terminal period, and the value of the infinite cash flows during the terminal period is known as terminal value. During this period business operations are considered to have achieved stability.
The Terminal Value is calculated thus:
TV= Cash flow from last projection year × (1+g) / r-g
Where g = growth rate
r = discount rate
Time of Cash Flow
The timing and analysis of time are two important parts of the management of cash flow in a business. You must be clear on when to expect incoming and outgoing payments. To achieve this, a cash flow budget is of utmost importance.
This will help you to make projections about the future inflows and outflows of cash in your business. Since cash flows occur during specific periods, you should project your cash flow within specific intervals. This will help you to know the monthly projected cash movement and the yearly cash flow projections.
The Enterprise Value is the totality of assets owned by a business or company. In a nutshell, these are the non-cash assets that a company has. The capital structure of a business is not taken into consideration when determining the enterprise value. Where equity, debt, and cash values are given, Enterprise Value can be mathematically expressed as:
EV = (Share Price × Number of Shares) + Total Debt – Cash
If a business has a minority interest, it must also be factored into the Enterprise Value.
Equity Value is the remnant value available to stakeholders after all external entitlements have been paid off. To find a company’s equity value, you need to use a levered free cash flow in a DCF model. If the Enterprise Value, Debt, and Cash are given, Equity Value can be mathematically expressed in this way:
Equity Value = Enterprise Value – Total Debt + Cash
Equity Value is also called Net Asset Value.
What Are the Downsides of DCF Analysis?
DCF Analysis has quite some disadvantages that plague companies and businesses. This prevents companies from having a clear picture of the state of the business, both in the present and the future. We’ll explain some of the downsides of DCF analysis below.
Operating Cash Flow Projections
So many variables in the projection of cash flow leave it vulnerable to errors. Where these variables are not given but assumed, the chances of getting misleading information are high.
Capital Expenditure Projections
DCF Analysis is far from perfect in regard to Capital Expenditure Projections. Many of the measures are estimated in isolation, without considering other entities that have a similar outlook. If the relative valuations of the competitors in the industry are not taken into consideration, then the company is merely groping in the dark.
Discount Rate & Growth Rate Assumptions
Since as many scenarios can be added and built into a DCF analysis, the process has been made complex. This is not necessarily a bad thing, however, an inordinate increase in built-in scenarios will cause negative complexity.
DCF analysis is a sure way to get a hold of your business and look into the future. Using this method, you can decide whether or not investing in a business is a good idea. However, do not make these decisions alone. Consult your Financial Advisor to gain a more detailed insight on the workings of the Discounted Cash Flow Analysis.