Discounted Cash Flow (DCF) – What It Is, Formula & Example

What is Discounted Cash Flow (DCF)?

Discounted Cash Flow is the most popular method of evaluating an investment based on the company’s projected future cash flows. The cash flows are ‘discounted’ back to their present value, which gives investors a fair idea of its true value. This basically means that investors try to figure out how much value will their investment today generate in the future. Discounted Cash Flow also aids the management in making decisions regarding their capital budgeting as well as operating expenses.

How does Discounted Cash Flow work?

The Discounted Cash Flow of an enterprise is also called its Net Present Value (NPV), which means that all future cash flows are discounted back to the time of investment to arrive at their value at that point in time. The underlying assumption in the DCF method is that the value of having money today is more than the value of the money received tomorrow (because it can be invested and grown). This is called the Time Value of Money.

Before we delve deeper into the Discounted Cash Flow calculation, let’s straighten out some terminologies that will ultimately come up in the formula and it will help you understand the rationale behind the formula’s structure. Discounted Cash Flow can be broken down into four essential components:

1. Cash Flow (CF)

Cash flow is the net cash an investor receives in the period under consideration for investing in the given security, i.e., stocks, bonds, etc. While calculating the Net Present Value (or Discounted Cash Flow), the cash flow used is also called the ‘unlevered free cash flow’ or ‘free cash flow.’ After subtracting the operating expenses, capital expenditure and working capital investments from the cash flow, you are left with free cash flow.

2. Discount Rate (r)

The rate of interest used in Discounted Cash Flow calculations is the Weighted Average Cost of Capital (WACC). Simply the cost of capital is the minimum return a business must generate before it starts creating additional value on investments. Therefore, WACC involves assigning weight to equity and debt based on the distribution of both in the company. So, if the invested security is a government bond, the discount rate will be the interest rate it pays.

3. Time Period (n)

Cash flows are considered over a stipulated time period. It can be months, quarters, or years. The time periods need not be the same, and if they are different, they must be expressed as a percentage of one year in the calculation.

4. Terminal Value (TV)

While it is relatively simpler to estimate cash flows for a limited period of time, it is much harder to foresee how the business will continue to perform after that. For this reason, a perpetual growth rate (g) is identified and used to arrive at this value. The formula is:

Formula

Having understood the four components of the calculation, let us take a look at the Discounted Cash Flow formula:

where,

CF_n = Free Cash Flow in the n^th period

Example of DCF

Let’s use the above formula in an example to understand Discounted Cash Flow better:

Let us assume that a company is trying to find its valuation based on its cash flow over a period of 5 years. It estimates that it will generate a free cash flow of ₹1 crore every year, and its WACC is 10%. After that, the company believes that it will continue to grow at 5%. Therefore,

n = 5 years

r = 5%

CF = ₹1,00,00,000

The NPV will be calculated as follows:

This means that discounted cash flow valuation of the company is ₹10,03,193.79.

Here are some examples of where DCF is used to arrive at the NPV:

• To find the valuation of an investment or a project within a company
• To find the value of a business within a company
• To value investments in securities like stocks and bonds
• To evaluate any income generating asset
• To evaluate any cost-saving measures implemented within an organisation.

FAQs

What are the benefits of using the Discounted Cash Flow model?

The Discounted Cash Flow approach is versatile and can be applied to various kinds of assets and can be used to value even entire businesses, projects or firms. Moreover, it does not rely on any peer comparisons and arrives at the present value of future cash flows based on logical assumptions.

How do I value a stock using Discounted Cash Flow?

A commonly used approach is to check the Cash Flow Statement of the company and identify the free cash flow for the last 3 or 5 years. Next, check its annual report to figure out the growth rate which the management predicts (this is your ‘r’). now simply plug the cash flows and discount rate into the Discounted Cash Flow formula (without the TV) to arrive at the present value of the stock. (This will be an approximate value).

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