What is a Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its future cash flows. DCF analysis finds the present value of expected future cash flows using a discount rate. A present value estimate is then used to evaluate a potential investment. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered.
DCF is calculated as follows:
CF = Cash Flow
r = discount rate (WACC)
DCF is also known as the Discounted Cash Flows Model.
Discounted Cash Flow (DCF)
BREAKING DOWN Discounted Cash Flow (DCF)
The purpose of DCF analysis is to estimate the money an investor would receive from an investment, adjusted for the time value of money. The time value of money assumes 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. Similarly, if a $1 payment is delayed for a year, its present value is $.95 because it cannot be put in your savings account.
A challenge with the DCF model is choosing the cash flows that will be discounted when the investment is large, complex, or the investor cannot access the future cash flows. The valuation of a private firm would be largely based on cash flows that will be available to the new owners. DCF analysis based on dividends paid to minority shareholders (which are available to the investor) for publicly traded stocks will almost always indicate that the stock is a poor value. However, DCF can be very helpful for evaluating individual investments or projects that the investor or firm can control and forecast with a reasonable amount of confidence.
DCF analysis also requires a discount rate that accounts for the time value of money (risk-free rate) plus a return on the risk they are taking. Depending on the purpose of the investment, there are different ways to find the correct discount rate.
An investor could set their DCF discount rate equal to the return they expect from an alternative investment of similar risk. For example, Aaliyah could invest $500,000 in a new home that she expects to be able to sell in 10 years for $750,000. Alternatively, she could invest her $500,000 in a Real Estate Investment Trust (REIT) that is expected to return 10% per year for the next 10 years.
To simplify the example, we will assume Aaliyah is not accounting for the substitution costs of rent or tax effects between the two investments. All she needs for her DCF analysis is the discount rate (10%) and the future cash flow ($750,000) from the future sale of her home. This DCF analysis only has one cash flow so the calculation will be easy.
In this example, Aaliyah should not invest in the house because her DCF analysis shows that its future cash flows are only worth $289,157.47 today. Once tax effects, rent, and other factors are included, Aaliyah may find that the DCF is a little closer to the current value of the home. Although this example is oversimplified it should help illustrate some of the issues of DCF including finding appropriate discount rates and making reliable future predictions.
Weighted Average Cost of Capital (WACC)
If a firm is evaluating a potential project, they may use the weighted average cost of capital (WACC) as a discount rate for estimated future cash flows. The WACC is the average cost the company pays for capital from borrowing or selling equity.
Imagine a company that could invest $50 Million in equipment for a project that is expected to generate $15 million dollars per year for 4 years. At the end of the project, the equipment that was used can be sold for $12 Million. If the company’s WACC is 12%, a DCF analysis can be completed.
In this case, the company should invest in the project because the DCF analysis results in a value that is greater than the $50 million initial investment.
Limitations of Discounted Cash Flow Model
A DCF model is powerful but there are limitations when applied too broadly or with bad assumptions. For example, the risk-free rate changes over time and may change over the course of a project. Changing cost of capital or expected salvage values at the end of a project can also invalidate the analysis once a project or investment has already started.
Applying DCF models to complicated projects or investments that the investor cannot control is also difficult or nearly impossible. For example, imagine an investor who wants to purchase shares in Apple Inc. (AAPL) in late 2018 and decides to use DCF to decide whether the current share price is a fair value.
This investor must make several assumptions to complete this analysis. If she uses Free Cash Flow (FCF) for the model, should she add an expected growth rate? What is the right discount rate? Are there alternatives available or should she just rely on the estimated market risk premium? How long will she hold AAPL’s stock and what will its value be at the end of that period? Unfortunately, there's a lack of consistent answers to these questions, and since she cannot access AAPL’s cash flow as a minority shareholder, the model is not helpful.
Discounted Cash Flow Model (DCF) Summary
Investors can use the concept of the present value of money to determine whether future cash flows of an investment or project are equal to or greater than the value of the initial investment. In order to conduct a DCF analysis, an investor must make estimates about future cash flows and the ending value of the investment, equipment, or other assets. An investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration. If the investor cannot access the future cash flows, or the project is very complex, DCF will not have much value and alternative models should be employed.