Everything you need to know about discounted cash flow (DCF): definition, calculation, advantages and limitations
Everything you need to know about Discounted Cash Flow (DCF): definition, calculation, advantages and limits
While most financial analyses are based on historical data, the discounted cash flow (DCF) method takes account of the future to estimate the value of a share or company. In the context of raising capital or when a strategic decision is to be made, the DCF method offers several advantages, despite some limitations to bear in mind. In this article, you will discover the advantages of the DCF method and how to calculate it.
Discounted Cash Flow Defined
Discounted Cash Flow (DCF) is an analysis method use to value a business.
It estimates the revenues that a company will generate by calculating free cash flow (FCF) and the net present value of this FCF. In other words, discounted cash flow tells investors how much a business is worth at a given time based on all the cash that it could make available to investors in future.
The method calculates the value of a business, especially innovative start-ups that are very often in the red in the first years. It can also be applied in other areas, such as property valuation or for share purchases.
Why calculate Discounted Cash Flow?
One of the main reasons for calculating the discounted cash flow of a business is to be able to define its value. Most investors and financial analysts use the DCF method when raising capital or in order to negotiate a merger or takeover.
Within a business, the DCF method also provides an indicator for making decisions concerning specific investments (new product launch, buying a new production unit, etc.). It also allows two or more opportunities to be compared based on the potential return on investment.
The DCF method can equally be used to analyse and estimate certain values in different areas. For example, it is possible to measure the value of a share or bond, the value of real estate, or the value of an investment or project.
As a general rule, remember that if you pay a price below the DCF value, your return on investment will be positive. On the other hand, if you pay more than the DCF value, you will lose out financially, which is a sign of a bad investment.
What are the advantages of the discounted cash flow method?
It is sometimes difficult to have a realistic and current valuation of a business. Whereas a lot of valuation methods use past performance to value a company, the DFC analysis measures it in terms of what it will yield in the years ahead by integrating the liquid assets it holds today. Following this logic, the business is considered to be worth the money that it will bring in.
By calculating the discounted cash flow of a business, a director or investor will have an accurate picture of the share value. The DFC method therefore has the advantage of taking account of a company’s future profitability now, and offering a better view of its outlook.
One last advantage is that a DFC analysis corrects the effects of an over- or under-valuation of a sector or market, predicting only the most accurate intrinsic value possible.
Calculating discounted cash flow
To correctly calculate discounted cash flow, four steps should be followed:
- Identification of free cash flow
- Evaluation of the discounting rate
- Choice of duration
- Calculation of terminal value
Step-by-step explanation of each item for the discounted cash flow calculation.
1. Identifying Free Cash Flow
Out of the different cash flows recorded in the financial statements of a business, only the free cash flow is used to calculate the discounted cash flow. It corresponds to the cash flow generated by a business, i.e. the cash in and cash out, weighted by the change in working capital requirement (WCR) and net investments.
The formula below can be used to calculate free cash flow:
Free cash flow = earnings after tax + net depreciation + net investments + change in WCR
2. Determining the discounting rate
After calculating future free cash flows, they must be discounted because £1 today will not be worth £1 in five years’ time, since the value of money decreases as the years go by. This discounting rate corresponds to the weighted average cost of capital (WACC), which depends on the profitability required by capital providers to finance the business, be it debt or equity financing.
WACC = cost des equity capital X (equity capital / (financial debts + equity capital)) + cost of debt X (1 – corporate income tax rate) X (financial debts / (financial debts + equity capital))
Note that: Specifying the discounting rate is essential in the DCF method. Even a slight variation in this rate can significantly impact the business valuation calculation. Therefore, the lower the variation, the more precise the valuation will be. The discounting rate varies with the degree of risk. It is around 10% to 15% for a very stable company. But it can reach 25% or even 50% for a newly founded start-up.
3. Choosing the duration
The third key factor in calculating discounted cash flow is the choice of the forecasting period. Note that too short a time horizon results in overlooking part of the available information. But conversely, predicting cash flows over the long term (beyond 10 years) can prove tricky.
It is therefore advisable to use forecasts between four and ten years. For a five-year estimate for instance, take your company’s actual cash flows for the next five years, and a "stable" cash flow for the sixth year and beyond.
4. Calculating the terminal value of the business
The last factor in the DCF analysis is based on calculating the terminal value (VT) of the business. This value corresponds to the projected cash flow growth rate over the coming years.
At the end of a forecast operating period, the company will continue its business for an indefinite period with an assumption of uniform growth over time: this is how we obtain its terminal value.
Note that: the terminal value corresponds to the value of the economic asset estimated in the last year of the business plan.
It is estimated using the Gordon and Shapiro formula:
TV = CF / (WACC - g)
Where CF = perpetual revenue g = perpetual growth rate of revenue from the asset (here the CF) t = discounting rate
Important: To determine the value of a business, an analyst calculates the present value of its future cash flows. Of course, the cash flows must be estimated reasonably, taking different factors into account that may impact future operating results.
Discounted Cash Flow Calculation Formulas
DCF is measured by dividing expected annual profits by a discounting rate based on the weighted average cost of capital (WACC) while waiving debt. The following formula is used:
DCF = (CF / (1+r)1) + (CF / (1+r)2) + (CF / (1+r)3) + (…) + (CF / (1+r)n)
Where CF = cash flow r = discounting rate n = year
For a five-year period, the formula for calculating DCF will therefore be:
DFC = Net cash flow first year / (1+ discounting rate) + Net cash flow second year / (1+ discounting rate)2 + Net cash flow third year / (1+ discounting rate)3 + Net cash flow fourth year / (1+ discounting rate)4 + Net cash flow fifth year / (1+ discounting rate)5 + Terminal value / (1+ discounting rate)5
Example of a Discounted Cash Flow Calculation
We will illustrate this formula with a practical example to measure the discounted cash flow of a business over three years.
Based on the figures provided by your company’s finance team, it generates £400,000/year in free cash flow and has a constant rate of 5% each year.
To calculate your cash flow (CF), start by multiplying your free cash flow by the constant rate: 400,000 x 0.05 = £20,000. Then add these £20,000 to your initial £400,000, equivalent to your cash flows for the following year: 20,000 + 400,000 = £420,000.
Calculate the cash flow for year 3: (420,000 x 0.05) + 420,000 = £21,000
Note: for this example, we will only take forecasts for the next three years into account. However, you can repeat the cash flow calculations according to the extent of your forecasts.
Now, let’s move on to the calculation of the business’ value using the DCF formula. For the moment, we have three calculations:
CF1: £400,000 CF2: £420,000 CF3: £441,000
Let's say your discounting rate is 15% per year (noted r in the DCF formula). This gives us:
DCF = (400,000 / (1+0.15)1) + (420,000 / (1+0.15)2) + (441,000 / (1+0.15)3)
DCF = 347,826 + 317,580 + 289,965
DCF = £955,371
In our example, the present value of your business is £955,371 over a three-year period. The DCF equation translates future cash flows into their present value. This value in based on the compounded rate of return (15% in our example) that you think you will obtain with your money today.
In this case, the growth rate (15%) is higher than your company’s cash flow (5%). A higher growth rate means that the discounted versions of your future cash flows will depreciate each year until they reach zero.
Calculating the terminal value: check points
Estimating the terminal value can be confusing and depends on two factors: the normalised cash flow and the growth rate. Calculating it is by no means trivial as it represents about 70% of the value in use of assets. Here’s what you need to remember.
Normalised cash flow
Determining normalised cash flow is necessary to calculate the terminal value, which is the market value of the operating assets at the end of the business plan. Put simply, the normalised cash flow calculation is generally based on the latest cash flow forecast of a business. This normalised cash flow defines a perpetual growth rate. Generally, the latest free cash flow is used as a basis to calculate normalised cash flow.
Terminal value formula:
Free cash flow for terminal value = Earnings before Interest, Taxes, Depreciation and Amortization of the last year +/- Change in WCR – investments
The second question concerns the growth rate of the GDP in the country or geographical area concerned. As it is calculated by the sum of all market player added values, GDP therefore integrates the growth of your company. Over the long term, your company should, therefore, logically grow at the same rate as GDP.
This argument can be countered by pointing out the disparities between sectors and areas of activity. A new company in the digital sector does not have the same growth objectives as an SME in import-export. In addition to incorporating your growth forecasts, you will need to find out about the prospects for your sector of activity.
Limits of the DCF method
Although the discounted cash flow model can be a very useful tool for valuing a business, it also has some limits that need to be considered:
● This model is very sensitive to assumptions. Now, predicting the future is often tricky, especially in very unstable times as the health crisis has already shown. Therefore, making assumptions does not lead to accurate estimates.
● Many external factors are excluded from the discounted cash flow formula. Like competition or market developments, analysts find it difficult to predict and integrate these factors which can nonetheless have a considerable impact on a business.
● The relatively complex calculation of the preliminary formulas for calculating DCF (free cash flow, discounting rate, terminal value) may only partially reflect an accurate result.
Although very useful and widely used, the discounted cash flow method can be coupled with other accounting and financial analyses to obtain the most accurate indications possible.
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