Discounted Cash Flow Analysis Definition
The definition of a discounted cash flow (DCF) is a valuation method used to value an investment opportunity. Discounted cash flow analysis tells investors how much a company is worth today based on all of the cash that company could make available to investors in the future. It requires calculation of a company’s free cash flows (FCF) in addition to the net present value (NPV) of these FCFs. There are three major concepts in DCF model: net present value, discounted rate and free cash flow. Estimate all future cash flows and discount them for a present value. Generally, use the discount rate as the appropriate cost of capital. It also incorporates judgments of the uncertainty of the future cash flows.
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Discounted Cash Flow Analysis Formula & Example
Use the following formula to calculate Equity Value:
Use the following formula to calculate Enterprise Value:
Enterprise value = ∑Annual free cash flow to firm/(1 + cost of capital)^t + residual value/(1 + cost of capital)^t
Or use constant-growth free cash flow valuation model when free cash flow grows at a constant rate g. The free cash flow in any period is equal to free cash flow in the previous period multiplied by (1+g).
Free cash flow to equity is the cash flow available to the company’s common equity holders after all operating expenses, interests, and principal payments have been paid. Necessary investments in working and fixed capital have also been made. It is the cash flow from operations minus capital expenditures minus payments to debt-holders.
Free cash flow to firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. It is the cash flow from operations minus capital expenditures.
For example, a company is projected to have fluctuating cash flows. Losses of $10,000 in the first two years, a gain of $20,000 in year 3, $45,000 in year 4 and $ 55,000 in the year 5… How much is it worth today?
Discount the cash flows at a rate acceptable to the investor – 18%.
Time Year 1 Year 2 Year 3 Year 4 Year 5 NPV Projected future cash flow -10,000 -10,000 20,000 45,000 55,000 Residual value 5,000 Projected annual free cash flow -10,000 -10,000 20,000 45,000 60,000 Discounted cash flows - 8,475 -7,182 12,173 23,211 26,227 45,953
This leaves a present value of $45,953. In conclusion, it indicates the estimated fair market value of the company today.
Discounted Cash Flow Analysis Applications
DCF valuation method used to estimate the attractiveness of an investment opportunity. Its analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, then the opportunity may be a good one.
Although DCF is good for investors to do a reality check, it does have shortcomings. DCF analysis is based on its input assumptions. For example, small changes in inputs (such as free cash flow forecasts, discount rates and perpetuity growth rates) can result in large changes in the value of a company. Investors must constantly second-guess valuations. This is because the inputs that produce these valuations are always changing and susceptible to error.
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