Discounted cash flow, or DCF, is a common method of valuing investments that produce cash flows. It is also a common valuation methodology used in analyzing investments in companies or securities.
The approach attempts to place a present value on expected future cash flows with the assistance of a “discount rate”.
Below is a brief definition of discounted cash flows, the benefits of using DCF valuations, and the basics of calculating a DCF.
What Is a DCF?
Discounted cash flow is a valuation technique that uses expected future cash flows, in conjunction with a discount rate, to estimate the present fair value of an investment. It is a calculation that is concerned with the time value of money, or TVM.
TVM is the idea that money today is worth more than money tomorrow. This assumption is based on the premise that today’s dollars could be invested and therefore appreciate in value over time. Time value of money is a pillar concept of modern finance.
DCF analysis is a useful technique to evaluate any investment that requires a present day cash outlay in exchange for future earnings.
Why is DCF Important?
Discounted cash flow models are used to estimate the value of an asset. It is considered a fundamental analysis technique, meaning it is both quantitative and qualitative in nature.
DCF models require detailed assumptions that are used to forecast future cash flows. In drafting these assumptions analysts put a great deal of effort into identifying economic, environmental, and social issues that impact future free cash flow.
Because of this, DCF analysis is seen as comprehensive and is widely viewed as an industry standard in estimating the fair value of an investment.
DCF calculations also rely on a wide variety of data, including cost of equity, the weighted average cost of capital (WACC), and tax-rates.
WACC is, “A calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation”
The DCF model relies on free cash flow (FCF), which is a reliable metric that reduces the noise created by accounting policies and financial reporting.
One key benefit of using DCF valuations over a relative market comparable approach is that the calculation is not influenced by marketwide over or under-valuation.
It’s critical that the assumptions that are being input into a discounted cash flow model are accurate—otherwise, the model tends to lose its effectiveness.
How to Calculate Discounted Cash Flows (DCF)
Because DCF models depend on free cash flow, calculating a DCF is both a progressive and cumulative process.
How to calculate free cash flow (FCF)
Free cash flow is the amount of cash a business creates after considering all cash outflows. One of the impacts accounting policies have on financial statements is the implication of non-cash expenditures.
FCF is a measurement of profitability that eliminates these non-cash expenses and includes cash expenses for acquiring assets and changes in working capital over a given period of time.
The formula for calculating FCF is:
FCF = cash flow from operations + interest expense – tax shield on interest expense – capital expenditures (CAPEX).
There are other ways to calculate FCF, including:
FCF = [EBIT x (1-Tax Rate)] + non-cash expenses – change in current assets/liabilities – CAPEX
FCF = net income + interest expense – tax shield on interest expense + non-cash expenses – change in current asset/liabilities – CAPEX
Any of these formulas is appropriate depending on what information is available.
How to calculate DCF
Once free cash flow is calculated, it can then be used in the DCF formula. As mentioned, the DCF formula relies on the use of a discount rate.
The discount rate in this context is the required rate of return an investor seeks to gain from paying today for future cash flows. Often, analysts will use a business’ weighted average cost of capital (WACC), a required rate of return, or market averages.
The basic formula for calculating discounted cash flows is:
FCF = FCF for a given year
FCF1 = FCF year 1
FCF2 = FCF year 2
FCFn = each additional year
n = additional year
r = Discount Rate
Using WACC in a DCF
When an organization is reviewing multiple investment opportunities it is typically prudent to use Working Average Cost of Capital , or WACC, as the discount rate in the DCF formula. WACC takes all of the components that make up working capital and proportionately weights them to arrive at an average cost of capital.
WACC is calculated as follows:
E = Market value of the business
D = market value of the businesses debt
V = E + D
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate
WACC is an extensive topic that’s worth mentioning here because it is the industry best practice for assessing an appropriate discount rate when analyzing various projects within an organization.
Other DCF Considerations
Since DCF analysis is so dependent on the use of an accurate discount rate, a great deal of care should go into identifying the appropriate one.
Investors will often use the required rate of return in conjunction with market conditions that are being displayed. In certain cases, a blended discount rate might be used that reflects various scenarios.
Using DataRails to Build Your DCF Model
Every finance department knows how tedious building a DCF model can be. Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails’ FP&A software is an enhanced data management tool that can help your team create and monitor budgets faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes budgeting from time-consuming to rewarding.