- The Concept of Time Value of Money (TVM)
- What is the Discounted Cash Flow (DCF) Model?
- What Are the Essential Components of the Discounted Cash Flow Model?
- How to Calculate the Discounted Cash Flow (DCF)?
- The Discounted Cash Flow Calculation
- What Are the Types of Discounted Cash Flow Techniques?
- What Are the Applications of Discounted Cash Flow Analysis?
- The Pros and Cons of Using the DCF Model
Most entrepreneurs and investors often come across the jargon Discounted Cash Flow (DCF). The term holds considerable significance in the investment world. The science behind using the DCF analysis lies in the concept of the time value of money (TMV).
Most investors and business owners desire to receive money in the present over receiving an equivalent sum in the future. The comprehension of this precept is indispensable to help you make smarter investment choices.
The Concept of Time Value of Money (TVM)
The time value of money (TVM) is the concept that the actual worth of your monetary assets in the present tends to exceed its value for an identical sum in the future. As one can use their monetary assets on hand today to earn compounded interest, it enhances the actual worth in the present in contrast to the same sum in the future. Another reason for the decline of the value of money in the future is inflation. It degenerates the worth of a given amount of money over time. The time value of money lays the foundation for the DCF model.
What is the Discounted Cash Flow (DCF) Model?
The DCF model assists in investment appraisal by using the cash flows you can expect from the proposed future investment. One has to use an annual discount rate to calculate the discounted value of these future cash flows. You can thus ascertain the present value of the cash flows using the calculation under the DCF model.
The prevalence of the DCF model has remained in the finance and business domain since the 1700s. Its popularity spiked in the latter half of the 20th century, and it continues to remain a predominant part of the investment decision-making process.
Before discussing how you can use the Discounted Cash Flow model, let's take a look at the relevant components of the DCF model.
What Are the Essential Components of the Discounted Cash Flow Model?
The metrics of the discounted cash flow consist of the following key components:
- 1. Yearly Cashflows: This component refers to the annual cash flows you can forecast to yield through a given project or investment proposition. It represents the net figure you can estimate to derive yearly after adjusting the cash inflows and the outflows.
- 2. Terminal Value: It's the overall worth of the asset or investment proposal after the end of the expected time frame up to when the estimation of future cash flows is possible. It represents the present worth of the cash flows derived from the assumption that the project shall attain a stable growth rate after the forecasted duration.
- 3. Expected Time Duration: It denotes the time horizon you can forecast to generate the cash flows from the relevant investment project.
- 4. Discount Rate: You can define the discount rate as the rate of return from a given investment. In most cases, analysts use the weighted average cost of capital (WACC) as the discount rate. WACC connotes the blended cost of financing the investment using the main components of debt and equity.
How to Calculate the Discounted Cash Flow (DCF)?
It is now time to understand the crux of the DCF model with the formula for discounted cash flow analysis and the calculation under the discounted cash flow model.
The Discounted Cash Flow Formula
Usually, investment experts use the following formula to estimate the discounted cash flow for any project.
DCF = (Year 1 CF/ ( 1+r)^1 + Year 2 CF /(1+r)^2 + Year 3 CF/ (1+r)^3 +..+ Year n CF/ (1+r)^n)
CF signifies the respective cash flow for the given year.
r represents the discount rate
n indicates the terminal year for the project.
The Discounted Cash Flow Calculation
Let's explore the calculation of the discounted cash flow with a hypothetical scenario.
Mr. Smith invested in a business venture Acme Corporation €10,000 in 2021. The expected duration of this investment is 5 years, and the discount rate is 5 percent. The projected cash flow Smith can expect from the investment is as follows.
DCF = (€1000/ (1+5%)^1 + €1200/ (1+5%)^2 + €500/ (1+5%)^3 + €1400/ (1+5%)^4 + €1500/ (1+5%)^5)
Using the formula, we derive the following yearly discounted cash flows that Mr. Smith can expect in each of the following five years.
The total discounted cash flow at the end of the 5 years is €4779.24. It means that for the investment of €10,000 at the start of 2021, Smith will incur a loss of €5220.76 given the net present value. Thus, this investment is not fruitful for Mr. Smith.
It is evident from this case how you can scrutinize your decisions regarding different forms of investments using the discounted cash flow model. One must also note that the calculation of the discounted cash flow is possible using more than one technique. Hence, let us look into the major types of DCF techniques.
What Are the Types of Discounted Cash Flow Techniques?
There are two primary forms of DCF techniques that can help entrepreneurs and investors make wise investment decisions.
The Internal Rate of Return (IRR) Method
The Internal Rate of Return (IRR) is nothing but the discount rate used to get a zero Net Present Value (NPV) of all predicted future cash flows over the expected time duration of the investment. Using IRR, you discount your cash inflows and outflows so that their present values are equal. When you use the IRR method, you consider an investment-worthy if the expected minimum rate of return is more than the IRR.
The Net Present Value (NPV) Method
Under the Net Present Value (NPV) method, you have to obtain the present value after discounting the forecasted cash inflows of the investment. Then, you estimate the present values of the expected cash outflows over the tenure of the investment. Finally, you deduct the initial investment sum coupled with the present value of the cash outflows from the discounted cash inflows.
The standard formula is as follows.
NPV = (Year 1 CF/ ( 1+r)^1 + Year 2 CF /(1+r)^2 + Year 3 CF/ (1+r)^3 +..+ Year n CF/ (1+r)^n) – Initial Investment
In case your NPV is positive, you can consider the proposed project as an appropriate investment. On the flip side, a negative NPV points out the possibility of loss from the investment proposal.
What Are the Applications of Discounted Cash Flow Analysis?
After exploring the theoretical aspects of the discounted cash flow method, it's time to get an overview of its relevance in practical life. The DCF model finds its utility for various forms of investment decisions. You can use the insights obtained using the discounted cash flow techniques in multiple domains.
Some of the notable applications of discounted cash flow analysis include:
- 1. You can use it for the evaluation of future real estate projects.
- 2. If you are planning to launch a startup, you can use the DCF model to assess the feasibility of your business idea with the data regarding capital invested and predictable future revenue inflows.
- 3. Individuals in corporate financial management also employ the discounted cash flow analysis for their financial decision-making requirements.
- 4. Business entities use the DCF model to value their business endeavors along with other purposes like patent valuations. Thus, it can assist in decisions related to divestment or mergers and acquisitions.
- 5. Many entrepreneurs utilize the discounted cash flow method to peruse the decisions related to purchasing heavy equipment and long-term assets for their entity.
- 6. The discounted cash flow analysis also has significance in the realm of stock market investments. The DCF model can help review the stocks and bonds that can prove more rewarding for investors.
The Pros and Cons of Using the DCF Model
If you plan to utilize the discounted cash flow model to scrutinize your investment proposals, you should stay wary of the pros and cons involved. The discounted cash flow analysis comes with its own set of benefits and inherent drawbacks.
What Are the Advantages of Using the DCF Model?
- 1. The DCF model is considered better than most valuation methods: As the discounted cash flow analysis accounts for cash flows expected in the future, one can derive more trustable conclusions from this method than other accounting techniques.
- 2. Lower effect of market conditions and non-economic aspects: The DCF model does not get highly impacted due to external elements such as non-economic and market conditions in contrast to other valuation models.
- 3. Enables derivation of quite precise valuation estimates: While using the discounted cash flow analysis, we most likely gain the near-exact intrinsic worth of any business or asset. Due to the use of components such as growth rate and WACC, more and more investors rely on the DCF model.
What Are the Disadvantages of Using the DCF Model?
- 1. Sensitivity of the results to minute variations: The values estimated using the discounted cash flow model remain entirely subjective to even the slightest variances in the components, such as the discount rate or time duration.
- 2. Inaccuracies in the predictions of future cash flows: In many cases of evaluating the investment proposals, the estimation of the correct future cashflows can be tricky. This factor leads to the occurrence of inaccurate discounted values.
- 3. Might not be adequate for short-term investment evaluations: The fluctuations in the business functioning and environment tend to constantly affect the figures related to the growth rate and terminal value. Hence, the use of this model for short-term decision investment needs can prove perplexing.
Regardless of some downsides, the DCF model stands as one of the widely used methodologies for evaluating investment options. Financial experts and business people vouch for its usability as it helps infer very reliable valuations of assets and business entities. Undeniably, you can count on discounted cash flow analysis for nimble financial and investment decisions.