What Is Discounted Cash Flow (DCF)?
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Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is a method used to estimate the future returns of an investment. It takes into account the future value of money — the idea that a dollar that is ready to be invested now is worth more than one you are expecting to receive in the future.
Discounted cash flow (DCF) is a method for estimating the value of a present investment based on predictions of its future cash flow.
The DCF method rests on the assumption that a dollar you have today is worth more than a dollar you might receive in the future as a return on an investment. This is called the time value of money. The idea is that a dollar you have today can be invested immediately, and generate a return, whereas a dollar you are expecting to receive in the future can’t be used until you actually have it.
For example, if you have $1 today, you can invest this in a regular savings account. You might receive a 5% annual interest rate on this investment, so the $1 will be worth $1.05 in a year. If you are expecting to receive the same $1 in one year’s time, its present value is 95 cents, because you could have invested it if you'd had it earlier.
A discounted cash flow (DCF) calculation is a way of taking this into account for complex investments. To perform a DCF calculation, you first estimate the discount rate and then apply this to all the predicted returns of a given investment. The discount rate is estimated by taking into account a variety of factors, including the cost of financing the investment and future economic conditions.
For example, if you invest $10 million in a project today, and the project is expected to generate $12 million in returns over the next five years, you might imagine that your gross return is $2 million. However, this is not quite correct, because you’ll have to wait five years to see a return, and you could’ve invested the same $10 million in a different way in the meantime.
A DCF calculation potentially provides a more accurate assessment of the actual return on your money. If the DCF is lower than the cost of the present investment, this could indicate that it is unlikely to generate a profit.
How to calculate discounted cash flow
DCF is calculated using a formula. In order to use the formula, you need to know two pieces of information: the expected returns of an investment, and the discount rate (DR).
The first step in calculating DCF is to estimate the discount rate. This is the rate at which future returns depreciate over the course of the investment. Many companies use the weighted average cost of capital (WACC) as an approximation of the discount rate. The WACC for a given company takes into account the cost of financing an investment, and also the return that shareholders are expecting each year.
You can then apply the discount rate to the expected returns of an investment using the DCF formula.
The discounted cash flow formula
The formula for DCF is:
Example of discounted cash flow (DCF)
Let’s take an example to calculate the DCF of a specific investment.
First, we estimate our discount rate using the weighted average cost of capital (WACC) as an approximation. WACC rates vary a lot by company, but for this example we’ll assume a company has a WACC of 5%, and use this as the discount rate.
Now, assume that a company is considering investing $10 million in a new project, and the project is expected to generate $12 million in cash flow over the course of five years, with the yearly returns on the investment distributed as follows:
|Year||Annual cash Flow|
Now, using the formula above, we can calculate the discounted cash flow of this project over its lifetime:
|Year||Annual cash flow||Discounted cash flow|
Notice that the annual cash flow in the last three years of the project decreases each year. Instead of receiving a straightforward $3 million each year, the actual value of these returns is less, because this money could’ve been invested in different ways at the beginning of the period we are considering.
Notice, also, that using the discounted cash flow to assess this particular project, instead of just using the raw cash flows, suggests that it is a much less profitable investment than it first appeared.
Subtracting the DCF value ($10,176,639) from the initial cost of the investment ($10 million) gives us the net present value of the investment: $176,639. Since this is a positive number, we would still expect the investment to generate a profit, but only just. In addition, if we’ve made a mistake estimating the discount rate, the project could easily make a loss.
Advantages and disadvantages of DCF
Discounted Cash Flow (DCF) is widely used in business, including in a number of key models for valuing stocks such as the Gordon Growth Model. It can provide investors and companies with a far more accurate picture of the actual returns of a project than relying on gross cash flow estimates alone. However, the model also has a number of key drawbacks.
Advantages of DCF
DCF can be reasonably easily applied to a wide variety of investments and projects, as long as the estimates of cash flow and the discount rate are accurate.
The relative simplicity of the DCF formula means that estimates of the net present value of an investment can be easily changed. This provides a way of quickly testing out different scenarios.
Disadvantages of DCF
The main disadvantage of the DCF model is that it is an estimate that, in turn, in based on other estimates. Both of the key pieces of information needed to calculate DCF — future cash flows and the discount rate — can be unreliable.
The predicted cash flow of a project or investment can depend on a variety of factors: market demand, the status of the economy, technology, competition and unforeseen threats or opportunities. These are difficult to quantify exactly, and small underestimates can greatly affect eventual returns.
Similarly, the discount rate is an estimate, and its actual value can vary depending on the cost of financing the initial investment, other investment opportunities that might arise during the course of the initial investment, and the return that shareholders expect.
Discounted cash flow FAQs
How do I calculate DCF?
Calculating DCF involves three steps. First, you must estimate the future cash flows of a project or investment. Second, you must estimate the discount rate. Then, you can use these figures in the Discount Cash Flow formula to calculate the actual value of the investment at the present moment.
Is discounted cash flow the same as net present value (NPV)?
Discounted cash flow (DCF) and net present value (NPV) are related, but are not synonyms. In order to calculate NPV, you must first perform a DCF calculation. Then, you subtract the upfront cost of the investment from the DCF value.
In our example above, the initial cost of the investment was $10 million, and we calculated that the DCF would be $10,176,639. This gives a net present value of $176,639.
Advantages of discounted cash flow
The discounted cash flow model can provide investors and companies with a far more accurate picture of the expected returns of an investment or project than relying on cash flow projections alone. The relative simplicity of the formula also allows analysts to quickly calculate the impact of different assumptions and scenarios.
Disadvantages of discounted cash flow
The main disadvantage of the DCF model is that it is an estimate that is based on estimates. Neither the expected cash flow from an investment nor the discount rate can be precisely calculated in advance of an investment, and inaccuracies in either can affect the expected returns.
Discounted cash flow key takeaways
Discounted cash flow (DCF) can be a good way for companies and investors to calculate the value of an investment. The DCF model can provide a more accurate picture of the actual returns of an investment than relying on expected cash flows alone. However, an accurate discounted cash flow value (and therefore net present value) of an investment is dependent on accurate estimates, and this is not always possible.
For this reason, investors should take into account a variety of other known factors when deciding on an investment. In addition, it’s often worth performing other types of analysis — comparable company analysis and precedent transaction analysis, for example — before going ahead with an investment.