Discounted Cash Flow (DCF)
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What is Discounted Cash Flow (DCF)?
The value of an investment can be determined using the discounted cash flow method (DCF), which measures the value based on expected future cash flows (cash flow, cash inflow or surplus of cash inflow). Therefore, DCF aims to estimate the return on an investment that an investor would receive, adjusted for the time value of money. Based on the time value of money, one franc today is worth more than one franc tomorrow. It assumes that the franc can be invested alternatively, thereby increasing its value.
DCF analysis estimates the present value of the expected future cash flows of an investment using a discount rate (see also discounting). Investors can use DCF analysis to determine whether the future cash flows of an investment or project are equal to or higher than the value of the original investment. In this way, it is possible to determine whether the investment is worthwhile. An investment should be considered if the DCF analysis results in a value higher than the initial value of the investment.
DCF analysis relies on assumptions, which limits its usefulness. To make a successful investment, the investor must accurately estimate cash flows. Cash flows, however, depend on many factors, such as market demand and the economic situation. There must also be a good estimate of the discount factor.
The Calculation of Discounted Cash Flows
CF : Cash flow for year n
r : The discount factor
Example: Calculation of the Discounted Cash Flow
DCF analysis allows companies to decide whether certain investments are worthwhile. A company's weighted average cost of capital is typically used as the discount factor. The shareholder value principle states that a company should generate at least the cost of capital over the long term. The cost of capital can be defined as what the capital market demands as compensation for investments with a particular level of risk and maturity. As a result of the shareholder value principle, cash flows are discounted by the cost of capital. The WACC method (before tax) and the MECC method (after tax) are common approaches to calculate the cost of capital.
In this example, we will assume that the initial investment in the project is CHF 500,000. In this case, the project will last for five years and the company will have a WACC of 7%. The investment generates cash flows of CHF 100,000 per year. When the annual cash flows are discounted with the WACC, the sum of the discounted cash flows equals CHF 410'020. Considering the DCF-value of this project is less than the amount invested in CHF 500,000, the project is not worthwhile. The net present value (NPV), which should be positive, is calculated by subtracting the initial investment from the sum of the discounted cash flows.
If the project would generate a cash flow of CHF 100,000 in year 1, CHF 120,000 in year 2, CHF 140,000 in year 3, CHF 160,000 in year 4 and CHF 180,000 in year 5, the sum of the discounted cash flows would be CHF 562,935. In this case, the investment would be worthwhile as the NPV would be positive. The calculations are shown in the table below:
The DCF Method for Business Valuations
Among other methods, the DCF method is still widely used in business valuations today. The fair value of a company is determined by evaluating its future cash flows. The expected series of returns over the duration T of the investment is added to the terminal value. The free cash flow is used as the basis for the calculation. The free cash flow is the cash flow that can be distributed without affecting the current business plans.
The DCF Formula for Company Valuation with Terminal Value
Example : Calculation of the Enterprise Value with Growth Rate with DCF Method
Company Y expects the following free cash flows (in CHF million) for the next 5 years: 15, 15, 10, 40, 50. It is expected that free cash flows will grow by 5% per year in the subsequent years. The capital market requires discounting with R = 10%. What is the enterprise value of company Y?
In order to determine the value per share, the enterprise value must be divided by the number of shares issued. This value can be compared with the current stock market price of the share. An investor who uses the value investing approach attempts to find shares that are undervalued, whose stock market price is lower than their calculated value per share. In contrast, if the current stock market price exceeds the calculated value per share, the stock may be overvalued.
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