Investors and financial analysts rely on various methods to assess the value of an investment or a business. These methods include Comparable Company Analysis, Discounted Dividend Method (DDM), Discounted Cash Flow (DCF), etc. However, DCF is one of the most widely used and fundamental approaches used in analysing shares of any company. DCF is a powerful financial tool that helps determine the intrinsic value of an asset by estimating the present value of its expected future cash flows. In this article, we will delve into the DCF terminology.
What is DCF?
Discounted Cash Flow is a financial modelling technique used to evaluate the worth of an investment or a business based on the Net Present Value (NPV) of its expected future cash flows. It operates on the premise that a dollar received in the future is worth less than a dollar received today due to the time value of money.
Check out the Net Present Value (NPV) Calculator
Use of DCF
DCF analysis finds extensive applications in various areas of finance and investment, including:
- Business Valuation: Investors use DCF to determine the value of a business or company.
- Investment Analysis: It helps investors assess the attractiveness of stocks, bonds, real estate, and other investment opportunities.
- Project Evaluation: Companies use DCF to evaluate the profitability of potential projects or investments.
- Mergers and Acquisitions: DCF is employed to estimate the fair value of a target company.
How to Calculate Discounted Cash Flows?
As discounted cash flow models depend on free cash flow, calculating a DCF is both a progressive and cumulative process. Hence, let us first understand the calculation of FCF.
Calculation of Free Cash Flow (FCF)
The amount of cash a business generates after deducting all cash outflows is known as free cash flow. The implications of non-cash expenses are one-way accounting principles that affect financial statements.
When these non-cash costs are subtracted, the profitability is measured using free cash flow, which also takes into account cash outflows for asset acquisition and working capital fluctuations over a certain time period.
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
And:
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.
Calculation of Discounted Cash Flow
The formula for calculating discounted cash flows is:
DCF= FCF1/ (1+r)^1 +FCF2/(1+r)^2+FCFn/(1+r)^n
Where:
FCF = FCF for a given year
FCF1 = FCF year 1
FCF2 = FCF year 2
FCFn = each additional year
n = additional year
r = Discount Rate
Use of WACC in a Discounted Cash Flow
WACC stands for Weighted Average Cost of Capital. It is a crucial financial concept used in corporate finance and investment analysis. WACC represents the average cost of financing a company’s operations, including both debt and equity, and it is used as the discount rate in various financial calculations, such as Discounted Cash Flow (DCF) analysis.
Here’s how the components of WACC work:
- Cost of Equity (Re): This is the return expected by the company’s shareholders or equity investors. It represents the cost of using equity financing to fund the company’s activities. The cost of equity is often estimated using methods like the Capital Asset Pricing Model (CAPM) or the Dividend Discount Model (DDM).
- Cost of Debt (Rd): This is the cost of borrowing money through debt instruments, such as loans or bonds. It includes the interest rate the company pays on its debt. The cost of debt is relatively straightforward to calculate because it is usually based on the interest rate paid to debt holders.
- Tax Rate (Tc): This represents the corporate tax rate applicable to the company’s earnings. Interest payments on debt are typically tax-deductible expenses for businesses, which means the company can reduce its taxable income by deducting the interest paid on debt.
The formula for calculating WACC is as follows:
Where:
E = Market value of the business
D = market value of the business 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’s best practice for assessing an appropriate discount rate when analysing various projects within an organisation.
Example of DCF
Suppose you are evaluating an investment opportunity with the following projected cash flows over five years.
Year 1: ₹1,00,000
Year 2: ₹2,00,000
Year 3: ₹3,00,000
Year 4: ₹4,00,000
Year 5: ₹5,00,000
Assuming a discount rate (WACC) of 10%, the DCF calculation would look like this:
DCF= ₹1,00,000/ (1+0.10)^1+₹2,00,000/ (1+0.10)^2+ ₹3,00,000/ (1+0.10)^3+₹4,00,000/ (1+0.10)^4+₹5,00,000/ (1+0.10)^5
DCF = ₹6,32,032.75.
What is Terminal Value?
The DCF method assumes cash flows will continue indefinitely, which is often not practical. Terminal value (TV) is an estimate of the value of an investment at the end of a forecast period, and it is used to account for all future cash flows beyond that period. The two common methods for calculating terminal value are the perpetuity growth model (Gordon Growth Model) and the exit multiple method.
Importance of DCF for Investors
- Informed Decision-Making: DCF provides a systematic and structured approach to evaluating investment opportunities, enabling investors to make well-informed decisions.
- Intrinsic Valuation: DCF calculates the intrinsic value of an asset, helping investors identify overvalued or undervalued assets, which can lead to more profitable investment choices.
- Risk Assessment: It forces investors to consider the risks associated with an investment by incorporating the required rate of return (discount rate), leading to a more comprehensive analysis.
Benefits of DCF
- Accuracy: DCF is a comprehensive and accurate valuation method when used with reasonable assumptions.
- Flexibility: It can be applied to various types of investments, from stocks to real estate.
- Incorporates Time Value: DCF recognises the time value of money, providing a more realistic picture of an investment’s value.
Limitations of DCF
- Sensitivity to Assumptions: DCF is highly sensitive to the inputs used, such as cash flow projections and discount rates. Small changes in these inputs can lead to significantly different valuations.
- Predictive Challenges: Accurately forecasting future cash flows can be challenging, especially for businesses with uncertain or volatile cash flow patterns.
- Long-Term Assumptions: DCF assumes cash flows will continue indefinitely, which may not hold true in all cases.
Conclusion
Discounted Cash Flow valuation is a fundamental tool for investors and financial analysts to assess the intrinsic value of an investment. By calculating the present value of expected future cash flows and considering factors like the weighted average cost of capital and terminal value, DCF provides valuable insights into investment decisions.
FAQs
Is DCF the only valuation method used by investors?
No, investors often use a combination of valuation methods, including DCF, comparable company analysis (CCA), and precedent transactions, to make more informed decisions.
What discount rate should I use in DCF analysis?
The discount rate, often represented by the WACC, should reflect the specific risks associated with the investment. It depends on the asset’s risk profile.
How do I estimate future cash flows for DCF analysis?
Forecasting future cash flows involves analysing historical data, market trends, and the company’s financial statements to make informed projections.
What is the difference between DCF and Net Present Value (NPV)?
DCF is a method used to calculate the NPV of an investment by discounting its future cash flows. NPV represents the difference between the present value of cash inflows and outflows.
Can DCF be used for startups or companies with negative cash flows?
Yes, DCF can be used for startups, but it may require more assumptions and be less accurate due to the uncertainty of future cash flows.
How often should I update my DCF analysis?
DCF analysis should be updated regularly to account for changing market conditions and financial performance. Many investors perform annual or quarterly updates.
