Discounted Cash Flow
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Discounted Cash Flow
What is Discounted Cash Flow?
DCF, which stands for Discounted Cash Flow, is a financial tool that determines the present value of a business, venture, or investment according to the cash flows it can make in the future. DCF uses a discounting factor for future cash flows since cash received in the future is always less valuable than cash received in the one at present.
The discounting of future cash flows is frequently used by companies and individuals to evaluate other companies, investments, and other assets that are forecasted to produce cash flows in the future.
The Discounted Cash Flow Formula
The basic formula for calculating DCF is:
| DCF Value = Σ [CFₜ / (1 + r)ᵗ] |
- CFₜ = the expected cash flow in period t
- r = the discount rate (reflecting risk and the cost of capital)
- t = the time period (year 1, year 2, etc.)
The calculation can also incorporate a terminal value when valuing a business over a long-term horizon. The discount rate and forecast period should be consistent with the timing and risk of the projected cash flows.
Applications of DCF
- M&A activities: Determining a reasonable purchase price for the acquired firm
- Valuation of startups/ firms: Particularly important in raising funds; however, difficult to use DCF in the case of early-stage startups due to lack of data
- Capital budgeting: Evaluating if a particular project or acquisition is worthwhile given the initial outlay
- Financial reporting: Valuing specific assets or liabilities under relevant accounting guidelines
Why the Discount Rate is So Important
The discount rate is the most important assumption made when developing a DCF model since even slight modifications may change the results greatly. The discount rate usually consists of several elements:
- Risk-free rate: Usually estimated based on the government bond yields and serving as the minimum “risk-free” return that can be earned;
- Market risk premium: Additional return required by the investor because he bears the risk of an asset which is not risk-free;
- Beta – A measure of volatility compared to the market;
- Specific risk associated with a company – Particular characteristics of the company
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