Discounted Cash Flow

Discounted Cash Flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. This method involves projecting future cash flows and then discounting them back to their present value using a discount rate. The discount rate reflects the time value of money and the risk associated with the investment. DCF is widely used in finance to value companies, projects, and other investments.

Importance of discounted cash flow analysis

Investment valuation

DCF is a fundamental tool for investment valuation, providing a comprehensive analysis of an investment’s potential profitability and risks.

Decision-making

DCF helps investors and managers make informed decisions about acquiring, holding, or selling assets by estimating their intrinsic value.

Capital budgeting

Companies use DCF to evaluate the feasibility of long-term projects and investments, helping to determine if the projected cash flows justify the initial outlay.

Risk assessment

By incorporating the time value of money and a discount rate that reflects risk, DCF provides a more accurate assessment of an investment’s risk and return profile.

Key components of DCF

Cash flows

The future cash flows used in DCF analysis typically represent the free cash flows (FCF) to the firm or equity. These are the cash flows generated by the investment after accounting for operating expenses, taxes, and capital expenditures.

Projection period

The projection period is the timeframe over which future cash flows are estimated. This period usually spans several years, depending on the nature of the investment and the reliability of forecasts.

Terminal value

The terminal value represents the value of the investment beyond the projection period. It is calculated using methods such as the perpetuity growth model or the exit multiple method. The terminal value often accounts for a significant portion of the total present value in DCF analysis.

Discount rate

The discount rate reflects the risk and time value of money. It is used to discount future cash flows to their present value. Common discount rates include the weighted average cost of capital (WACC) for firm valuation and the required rate of return for equity valuation.

Steps in conducting a DCF analysis

Step 1: Project future cash flows

Estimate the future free cash flows for the projection period. This involves analysing historical financial data, industry trends, and economic conditions to make realistic forecasts.

Step 2: Calculate the terminal value

Determine the terminal value at the end of the projection period using an appropriate method. Common methods include the perpetuity growth model and the exit multiple method.

Perpetuity growth model:

Terminal Value = FCF x (1+g) / r-g

Where:

• FCF = Free cash flow in the final projection year
• g = Perpetual growth rate
• r = Discount rate

Step 3: Determine the discount rate

Select an appropriate discount rate based on the investment’s risk profile. For firm valuation, use the weighted average cost of capital (WACC). For equity valuation, use the required rate of return.

Step 4: Discount future cash flows

Discount the projected future cash flows and the terminal value to their present value using the chosen discount rate. This involves applying the discount factor to each cash flow.

Present Value of Cash Flow:

PV = CF / (1+r)^t

Where:

• CF = Cash flow in year t
• r = Discount rate
• t = Year

Step 5: Calculate the total present value

Sum the present values of all projected cash flows and the terminal value to obtain the total present value of the investment.

Step 6: Make investment decisions

Compare the total present value to the initial investment cost. If the present value exceeds the cost, the investment is considered viable. Otherwise, it may not be worth pursuing.

Example of how to illustrate DCF

Consider a company planning to invest in a new project expected to generate $1 million in free cash flow annually for the next 5 years. The terminal value is estimated at $5 million, and the discount rate is 10%.

1. Projected cash flows:
   • Year 1: $1 million
   • Year 2: $1 million
   • Year 3: $1 million
   • Year 4: $1 million
   • Year 5: $1 million
2. Terminal value:
   • $5 million
3. Discount the cash flows:
   • Year 1: 1 / (1+0.10)¹ = 0.91 million
   • Year 2: 1 / (1+0.10)² = 0.83 million
   • Year 3: 1 / (1+0.10)³ = 0.75 million
   • Year 4: 1 / (1+0.10)⁴ = 0.68 million
   • Year 5: 1 / (1+0.10)⁵ = 0.62 million
   • Terminal Value: 5 / (1+0.10)⁵ = 3.11 million
4. Total present value:
   • 0.91 + 0.83 + 0.75 + 0.68 + 0.62 + 3.11 = 6.90 million
5. If the initial investment cost is $6 million, the project is viable as the present value ($6.90 million) exceeds the cost.

Conclusion

Discounted Cash Flow (DCF) is a powerful valuation method that helps investors and businesses assess the present value of future cash flows. By understanding and applying DCF analysis, one can make informed investment decisions, evaluate project feasibility, and manage financial risks effectively. For more information on DCF and its applications in Australia, visit the Australian Securities and Investments Commission.