Discounted Cash Flow (DCF) analysis

What is Discounted Cash Flow (DCF)?

Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.

This applies to the decisions of investors in companies or securities, such as acquiring a company, investing in a technology startup, or buying a stock, and for business owners and managers looking to make capital budgeting or operating expenditures decisions such as opening a new factory or purchasing or leasing new equipment.

How Discounted Cash Flow works？

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 because it can be invested. As such, a DCF analysis is appropriate in any situation wherein a person is paying money in the present with expectations of receiving more money in the future.

For example, assuming a 5% annual interest rate, $1 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 cents because you cannot transfer it to your savings account to earn interest.

DCF analysis finds the present value of expected future cash flows using a discount rate. Investors can use the concept of the present value of money to determine whether the future cash flows of an investment or project are equal to or greater than the value of the initial investment. If the value calculated through DCF is higher than the current cost of the investment, the opportunity should be considered.

Discounted Cash Flow formula

where:
CF=The cash flow for the given year.
CF1 is for year one, CF2 is for year two,CFn is for additional years
r=The discount rate

Disadvantages of Discounted Cash Flow

The main limitation of DCF is that it requires many assumptions. For one, an investor would have to correctly estimate the future cash flows from an investment or project. The future cash flows would rely on a variety of factors, such as market demand, the status of the economy, technology, competition, and unforeseen threats or opportunities.

Estimating future cash flows to be too high can result in choosing an investment that might not pay off in the future, hurting profits. Estimating cash flows to be too low, which would make an investment appear costly, could result in missed opportunities. Choosing a discount rate for the model is also an assumption and would have to be estimated correctly for the model to be worthwhile.

Source: Investopedia