Discounted Cash Flow Analysis

See Also:
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Steps to Track Money In and Out of a Company
Arbitrage Pricing Theory
Discount Rate
Required Rate of Return
(Discount Payback period) DPP

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:

Equity value = ∑Annual free cash flow to equity/(1 + cost of equity)^t + residual value/(1 + cost of equity)^t

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).

Equity value = Annual free cash flow to equity * ( 1+ g)/(cost of equity – g)

Enterprise value = Annual free cash flow to firm * ( 1+ g)/(cost of capital – 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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