Discounted Cash Flow

Introduction

Discounted Cash Flow is the valuation method of estimating an investment's value using the future cash flow. A DCF analysis can determine any investment's value depending on the amount of money an investment may generate in the foreseeable future.

The formula for DCF or discounted cash flow is equal to the cash flow's sum in every period divided by one plus the WACC or discount rate raised to the power of a period number. Discounted cash flow analysis helps entrepreneurs and managers make capital budgeting or expenditures decisions.
 

What is Discounted Cash Flow?

So, what is discounted cash flow? Discounted cash flow determines the overall value of any investment depending on future cash flows. The expected cash flow of the future's present value is offered using a projected discount rate. The overall opportunity may lead to positive results when the DCF is higher than the current investment cost.

Establishments use the WACC or weighted average cost of capital for a discounted rate for one reason. Note that it accounts for the overall rate of return that shareholders expect. 
 

How Does DCF Work?

DCF analysis helps estimate an investor's money received from the investment adjusted for the time value of money. Now, what do you mean by the time value of money? Simply put, it assumes that the dollar one has today can be worth more than one dollar received tomorrow because it can be invested. 

DCF analysis is valuable in any situation where an individual pays money in the present, expecting to get more money tomorrow.

With DCF analysis, one can find the present value of future cash flows via the discount rate. Also, investors may use the concept of present value to determine the cash flow of an investment in the future. 

The opportunity might be considered when the calculated DCF value is higher than the most recent investment cost. On the contrary, if the amount is lower than the cost, it can be a good opportunity. 

An investor can conduct the DCF analysis only after making future estimates with the ending value of the equipment, investment, or any other assets. An investor should determine the discount rate.

But note that the rate may vary based on the investment or project under consideration. Certain parameters also affect the discount rate, including the investor or company's risk profile, capital market conditions, etc.
 

Which Industries Can Use the Discounted Cash Flow Method?

As per the discounted cash flow techniques, a DCF can be used for estimating valuations like bonds, stocks, real estate, long-term assets, equipment, or business.

What is the Formula for Calculating DCF?

The formula for calculating DCF is:

DCF = [Cash flow for the 1st year divided by (1 + r)1] plus [Cash flow for the 2nd year divided by (1 + r)2] plus [Cash flow for 3rd year / (1 + r)3] + .. + [Cash flow for the nth year divided by (1 + r)n]
Where:

●    Cash flow encompasses the outflows and inflows of funds
●    R symbolises the discount rate
●    N describes the additional or final years

To get an insightful and practical understanding – here's outlining an example.

Suppose Mr. Adnani wants to make an investment of Rs. 1.5 lakh in his startup retail business for a tenure of 5 years. The WACC of the business is 6%. So, the estimated cash flow can be the following:
 

Depending on the discounted cash flow formula:

DCF is equal to [25,500 / (1 + 0.06)1] + [20,000 / (1 + 0.06)2] + [24,500 / (1 + 0.06)3] + [36,500/ (1 + 0.06)4] + [43,500 / (1 + 0.06)5] 

So, the DCF for every year will be the following:

So, the overall discounted cash flow valuation is Rs. 94340. When this amount gets subtracted from its initial investment of Rs.1 Lakh, the NPV comes down to -5660. Here, the NPV amount is a negative number. So, Mr. Adani's investment in his businesses won't be lucrative. In this manner, a budding entrepreneur can assess whether the investment will be profitable.

How to Calculate the WACC or Weighted Average Cost of Capital?

The investor may calculate the WACC before calculating the DCF amount. In that case, one should follow the given formula:

WACC is equal to (E / V x Re) plus [D / V x Rd x (1 - Tc)]

Here:

●    E means a business equity's market value
●    D is the business debt's market value
●    Re is the  equity cost 
●    V is the overall market value of the business financing, i.e., E and D
●    Rd is the debt cost
●    Tc is the corporate tax rate

Here's a narration that explains everything in brief:

Let's assume that a company XYZ has shareholder equity of Rs.50 Lakh (E). The long-term debt was around Rs.10 Lakh (i.e., D) for the 2019's financial year. Thus, the company's overall market value is Rs.60 Lakh (i.e., V = E + D).  

Now, let's anticipate that the company's Rd or debt cost or Re or equity cost is 6.4% and 6.6%, respectively. The corporate tax rate is 15%. To find out the value of WACC, let's use the given formula:

WACC = (50 divided by 60 multiplied by 6.6%) plus [10 divided by 60 x 6.4% x (1 plus 15%)]
= 0.055 plus (0.167x0.065x1.15)
= 0.067

So, WACC is 6.7% that XYZ's shareholders receive on average each year for financing the assets. 
 

What Do You Mean by the Terminal Value in DCF?

The terminal value in any DCF analysis happens to be the final causation. It is the projected growth rate of the cash flows for years over & above any considered period. The following are the two methods of calculating the value:

●    Exit Multiple Method: The financial metric of any establishment gets multiplied by the trading multiple
●    Perpetuity Method: The Terminal value is equal to [FCWnx (1 + g)] / (WACC – g). FCF is the free cash flow, while g is the FCF's perpetual growth rate.
 

Understanding the Top Perks of Discounted Cash Flow Methods

Here are the benefits of discounted cash flow methods:

●    Applied to different projects, firms, and other investments 
●    DCF informs the investment's intrinsic value, representing the necessary assumptions & attributes
●    Investors may build scenarios & mimic predicted cash flows for every scenario to check the change in returns under different circumstances