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What is a 'Discounted Cash Flow (DCF)'

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analyses use future free cash flow projections and discounts them, using a required annual rate, to arrive at present value estimates. A present value estimate is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

DCF = [CF/ (1+r)1] + [CF/ (1+r)2] + ... + [CF/ (1+r)n

CF = Cash Flow

r= discount rate (WACC)

DCF is also known as the Discounted Cash Flows Model.

BREAKING DOWN 'Discounted Cash Flow (DCF)'

Several methods exist when it comes to assigning values to cash flows and the discount rate in a DCF analysis. But while the calculations involved are complex, the purpose of DCF analysis is simply to estimate the money an investor would receive from an investment, adjusted for the time value of money.

The time value of money is the assumption that a dollar today is worth more than a dollar tomorrow. For example, assuming 5% annual interest, $1.00 in a savings account will be worth $1.05 in a year. Due to the symmetric property (if a=b, then b=a), we must consider $1.05 a year from now to be worth $1.00 today. When it comes to assessing the future value of investments, it is common to use the weighted average cost of capital (WACC) as the discount rate.

For a hypothetical Company X, we would apply DCF analysis by first estimating the firm's future cash flow growth. We would start by determining the company's trailing twelve month (TTM) free cash flow (FCF), equal to that period's operating cash flow minus capital expenditures.

Say that Company X's TTM FCF is $50m. We would compare this figure to previous years' cash flows in order to estimate a rate of growth. It is also important to consider the source of this growth. Are sales increasing? Are costs declining? These factors will inform assessments of the growth rate's sustainability.

Say that you estimate that Company X's cash flow will grow by 10% in the first two years, then 5% in the following three. After a few years, you may apply a long-term cash flow growth rate, representing an assumption of annual growth from that point on. This value should probably not exceed the long-term growth prospects of the overall economy by too much; we will say that Company X's is 3%. You will then calculate a WACC; say it comes out to 8%.

The terminal value, or long-term valuation the company's growth approaches, is calculated using the Gordon Growth Model:

Terminal value = projected cash flow for final year (1 + long-term growth rate) / (discount rate - long-term growth rate).

Now you can estimate the cash flow for each period, including the the terminal value:

Year 1 = 50 * 1.10 55
Year 2 = 55 * 1.10 60.5
Year 3 = 60.5 * 1.05 63.53
Year 4 = 63.53 * 1.05 66.70
Year 5 = 66.70 * 1.05 70.04
Terminal value = 70.04 (1.03) / (0.08 - 0.03) 1,442.75

Finally, to calculate Company X's discounted cash flow, you add each of these projected cash flows, adjusting them for present value, using the WACC:

DCF of Company X = (55 / 1.081) + (60.5 / 1.082) + (63.53 / 1.083) + (66.70 / 1.084) + (70.04 / 1.085) + (1,442.75 / 1.085)

DCF of Company X = 50.93 + 51.87 + 50.43 + 49.03 + 47.67 + 981.91

DCF of Company X = 1231.83

Our estimate of Company X's present enterprise value is $1.23 billion. If the company has net debt, this needs to be subtracted, as equity holders' claims to a company's assets are subordinate to bondholders'. The result is an estimate of the company's fair equity value. If we divide that by the number of shares outstanding – say, 10 million – we have a fair equity value per share of $123.18, which we can compare with the market price of the stock. If our estimate is higher than the current stock price, we might consider Company X a good investment.

Limitations of Discounted Cash Flow Model

Discounted cash flow models are powerful, but they are only as good as their inputs. As the axiom goes, "garbage in, garbage out." Small changes in inputs can result in large changes in the estimated value of a company, and every assumption has the potential to erode the estimate's accuracy.

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