Discounted cash flow is an income-based approach for valuing an asset. The discounted cash flow formula calculates what an asset is worth today using future cash flows as the basis.
In business settings, analysts may apply the DCF model to determine the value of another business. For example, a company that’s interested in an acquisition or merger may look at the discounted cash flows of comparable companies. But it’s also possible to use discounted cash flow analysis when making investment decisions inside a personal portfolio.
What is DCF?
Discounted cash flow is one of several valuation methods investors use to determine an asset’s value. The technical DCF model definition is: future cash flows multiplied by discount factors to obtain present values.
In simpler terms, discounted cash flow allows investors to estimate the value of something today based on its ability to generate cash flow in the future. This ties into the concept of the time value of money, which assumes that money is worth more now than it would be at some future date. This assumption reflects the possibility of increasing inflation rates or interest rate changes diminishing the value of money over time.
Here’s another way to think of discounted cash flow: It’s a way to predict or estimate future returns on a current investment, whether it’s a stock, a business purchase or something else. In other words, you can use the discounted cash flow formula to figure out if what you get out of an investment might equal or exceed what you put in.
How DCF Works and What It’s Used For
Discounted cash flow analysis provides an estimated value of an investment or asset, based on forecast cash flows to evaluate potential investment opportunities. Investors use DCF to calculate a rate of return and answer the question of how much money an investment can potentially generate, when adjusted for the time value of money.
DCF analysis can have several applications. Some of the scenarios where analysts use discounted as a predictive tool include when evaluating the potential returns on an investment:
• Calculating the value of a business
• Estimating the potential return on investment associated with the purchase of business assets
• Calculating the value of investments in stocks, bonds or other financial securities
Company’s often use DCF valuation when they are contemplating the acquisition of another company. In this scenario, discounted cash flow can give the acquiring company an idea of the value of the company they want to purchase.
Businesses can also use discounted cash flow analysis as a guide for making investments in equipment or other assets. If the investment requires the use of loans or financing to purchase the equipment, the DCF model can factor the interest rate into its calculations to estimate an accurate ROI.
Discounted cash flow uses a specific formula for determining value. The formula looks like this:
(Cash flow for year 1/(1+r)1) + (Cash flow for year 2/(1+r)2) + (Cash flow for N year/(1+r)N) + (Cash flow for final year/(1+r)
You may also see it simplified like this: DCF = CF1 / (1 + r) 1 + CF2 / (1 + r) 2 + CFN / (1 + r)N + CFF/ (1+r)
Breaking down each element of the discounted cash flow formula can help with understanding how to use it.
In the DCF valuation model, cash flow simply represents the flow of cash in and out of a business or investment. For example, a business’ incoming cash flow may revolve around sales of its products or services.
Outgoing cash flow would include expenses paid by the business, including payments to suppliers, utility bills, loan payments and taxes. Positive cash flow means the business has more money coming in than going out while negative cash flow means the opposite. A cash flow statement is a standard part of a company’s financial statements.
For a stock, the cash flow might be dividends paid, and for a bond it could be coupon payments.
In the discounted cash flow formula, “r” represents the discount rate. The discount rate is the interest rate used to determine present value. When using the DCF model to determine business valuations, the discount rate can be applied as the weighted average cost of capital.
The discount rate is important because when used in discounted cash flow analysis calculations, it can tell you if the expected return from an investment is likely to be positive or negative.
The final piece of the puzzle in discounted cash flow analysis is the period number, represented by N in the DCF formula. The period number simply means the period of time that you’re using for discounted cash flow analysis. So this might be five years, 10 years, 20 years, or longer, depending on the type of investment or asset you’re trying to find a valuation for.
When calculating discounted cash flow, you can also determine terminal value. This makes it possible to measure the growth rate or return on an investment for projected cash flows beyond the timeframe you’re using for your calculations. So to find this number, you’d multiply cash flow for the final year by (1+ long-term growth rate) and divided by (discount rate – minus long-term growth rate).
Having an example to follow can make it easier to understand discounted cash flow and how it works. So, assume an investor is considering a private equity investment. They plan to purchase a 10% stake in a private company growing at a rate of 5% each year.
Using the discounted cash flow formula, assume that the business generated $5 million in cash flow the previous year. A 10% investment stake would be worth $500,000. Using a 5% growth rate, the stake would generate $25,000 in cash flow the first year, $26,250 in the second year and $27,562.50 in the third year.
Now, say your target rate of return is 10%. Using the discounted cash flow formula with a discount rate of 0.10%, here’s how the numbers would align:
|Year||Cash Flow||Discounted Cash Flow|
Looking at this chart, you can see what an investment would be worth to you today, based on anticipated cash flows. This can help you decide how much to invest and if the investment is worth it, based on the expected rate of return you might get from putting the money to work elsewhere.
Discounted Cash Flow vs Net Present Value
Discounted cash flow is one of several valuation methods used to determine value of a business or investment. Net present value or NPV is another. The net present value represents the present value of cash flows at the required rate of return relative to the initial investment. Net present value can be used to decide if an investment is worth making, based on the expected rate of return as measured by the value of money today.
So how is this different from discounted cash flow? With discounted cash flow analysis, you’re trying to determine how much projected cash flows are worth using the time value of money. When using DCF analysis, the internal rate of return represents a discount rate that makes the NPV of cash flows equal to zero.
Net present value, on the other hand, can help you determine the net return on an investment after factoring in the initial cost of that investment. To calculate net present value, you’d use the initial investment amount, the discount rate or target rate of return, and the time period for the investment.
Both DCF and NPV can help when making investment decisions. But net present value takes valuation calculations one step further by subtracting the cost of the investment from the discounted cash flow.
Limitations of DCF
Discounted cash flow modeling is not an exact science. DCF analysis requires you to estimate cash flows and the discount rate, so if you estimate either one inaccurately you could end up with valuation calculations that are too high or too low. This can make it difficult to realistically judge the viability of an investment.
It’s also important to remember that valuations can be very sensitive to external factors, such as changing market volatility. It’s difficult to precisely forecast how an investment or business will react to increased volatility or other changes to market conditions. For that reason, discounted cash flow works best as a guide for estimating potential returns, rather than an absolute predictor of outcomes.
How Can DCF Help Investors?
DCF can tell investors if an investment is worth making, based on the anticipated returns.
So, say you want to buy a stock that looks promising. If you have all the appropriate numbers to plug into the discounted cash flow formula, you could reasonably estimate how much of a return you’re likely to see on your investment. Or if you’re considering purchasing a home to use as a rental property, discounted cash flow could tell you what level of returns you’re likely to see on your investment.
Again, it’s important to remember that discounted cash flow is not a 100% accurate way to measure estimated return on investment. But it can be a useful guide for determining whether an investment makes sense for your portfolio, based on your goals, risk tolerance and time horizon.
Investing is central to growing wealth over the long term and getting started can be easier than you might think. Understanding the basics of discounted cash flow is important when choosing stocks, bonds, or other securities for your portfolio. If you’re investing via a brokerage account or an Individal Retirement Account (IRA), where you choose to invest also matters.
By opening an online brokerage account on the SoFi Invest trading platform, you can start investing with as little as $5. It’s easy and convenient to begin building a portfolio from scratch. If you prefer a hands-off approach, automated portfolios offer diversification.
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