Business, Legal & Accounting Glossary
Discounted cash flow (DCF) is a valuation methodology used to estimate a security’s intrinsic value.
Discounted cash flow (DCF) is a valuation technique employed to judge the attractiveness of an opportunity for investment. DCF analysis utilizes free cash flow projections and then discounts them to reach a current value. This value is applied to appraise investment potential. Discounting is made generally by using a weighted average cost of capital method. Opportunity is believed to be good if the value calculated through discounted cash flow analysis is greater than the present cost of investment.
Discounted cash flow is expressed mathematically as:
DCF=CF1/(1 + r)1 + CF2 / (1 + r)2 +…+ Cfn / (1+r)n
where CF= cash flow r=discount rate
DCF technique has many defects. It is just a valuation technique that makes it susceptible to big changes in company valuations by minute inputs of data.
The discount rate in the equation reflects two points: the time value of money and risk premium. Risk premium enables investors to speculate additional returns as they wish to be recompensed for a possibility, if the flow of cash may not happen at all
As has been stated elsewhere, the value of a business is how much cash it can return to its owners over its lifetime. You would be small-f foolish to invest in a company that doesn’t give you anything back for your investment. The question, though, is how to avoid that? How do you find businesses that will give you a great return?
One way to start is to estimate a value based on estimates of the cash flows the business produces or may produce.
“Estimate” is the mot juste, not “calculate,” because the results from calculations like these are just that — estimates. They are based on several assumptions, any one of which can be wrong and throw off the whole thing without you realizing it. So, if you ever hear or read someone saying that “Microsoft is worth $39.57 per share,” run away. The best that could probably be said is that it might be worth anywhere from $30 to $50 per share. Intrinsic value is a fuzzy target, at best.
Back to estimating the value.
In a DCF model, one is estimating the cash that the business generates and which could be paid to the owners, the shareholders. If that cash flow is a dividend, then the model is called a dividend discount model. However, what if the company doesn’t pay a dividend? Other cash flows must be used.
A popular substitute is free cash flow (FCF), which may be simply defined as cash flow from operations (CFO) minus CAPEX. Both cash flow from operations and CAPEX are found on the statement of cash flows. Note that in calculating FCF, CAPEX is already a negative number, so don’t subtract the negative (which means adding). CFO – CAPEX and just go with it. Since FCF can be somewhat lumpy, it might be a good idea to use an average from two to five years.
Now you need a growth rate. How fast will the company grow free cash flow? That’s the question, now, isn’t it? And it is right here that the biggest errors creep in. People tend to overestimate how fast a company can grow. One idea is to look at the past several years, take an average, and then reduce that in stages. A three-stage model might take the last 3-years’ growth rate, apply it to the next five years, chop it in half for the next five years, and then reduce it to 3% (the long term rate of inflation, e.g. no “real” growth) from then on.
Maybe you should use several different sets, such as an “aggressive,” a “moderate,” and a “conservative” scenario.
Once you’ve got the growth rate, you need a discount rate. This could be the firm’s weighted average cost of capital (WACC). It could be Buffett’s 10-year treasury yield plus 5%. It could be your expected rate of return. It could be 12%, which is slightly better than the long-term return of the S&P 500. It could be weighted higher for “riskier” companies and lower for “safer” companies.
See the problem? The calculated intrinsic value varies greatly with the discount rate used and will be lower the higher the discount rate is. You want one that is reasonable. Maybe you should choose several to see what the calculation kicks out under different scenarios.
V_0 = \frac{CF_0*(1 + g)}{1 + r} + \frac{CF_1*(1+g)}{(1 + r)^2} + \frac{CF_2*(1 + g)}{(1 + r)^3} + … + \frac{\frac{CF_n*(1 + g)}{r – g}}{(1 + r)^n} = \frac{CF_1}{r – g}
Looks pretty hairy, huh?
Well, actually, all that is each year’s estimated cash flow (CF) — grown from the previous year by the estimated growth rate, “g” — discounted back to present-day dollars by the discount rate, “r.” Note that it starts off with next year’s estimated cash flow because this is an estimate of future cash flows.
So, if you had a 2-stage model of 3 years growth at 10% and 3% thereafter, with a 12% discount rate, and $1,000 in starting FCF, it would look like:
V_0 = \frac{$1,000*(1.10)}{1.12} + \frac{$1,100*(1.10)}{(1.12)^2} + \frac{$1,210*(1.10)}{(1.12)^3} + \frac{\frac{$1,331*(1.03)}{0.12 – 0.03}}{(1.12)^3}
V_0 = $982.14 + $964.60 + $947.38 + $10,842.23 = $13,736.36
Using Excel, the above is done as follows:
| A | B | C | D | E | |
| 1 | Rate | Year | CF | DCF | |
| 2 | g1 | 10% | 0 | $1,000.00 | |
| 3 | g2 | 3% | 1 | =D2*(1+B2) | =D3 / ((1+B4)^C3) |
| 4 | r | 12% | 2 | =D3*(1+B2) | =D4 / ((1+B4)^C4) |
| 5 | 3 | =D4*(1+B2) | =D5 / ((1+B4)^C5) | ||
| 6 | Terminal | =(D5*(1+B3)) / (B4-B3) | =D6 / ((1+B4)^C5) | ||
| 7 | |||||
| 8 | Total | =sum(E3.E6) |
It is described as a technique for ascertaining the present worth of an investment, a company, a balance sheet, and a portfolio. Asset valuation tool includes financial statement analysis, fundamental analysis, valuation economics, and quantitative methods and statistics.
Time value of money is the idea that money usable at present is worth more than the equivalent amount usable in the future. This is due to its probable earning capacity. For example, a quantum of money deposited in a savings account earns interest. Time value of money holds that any money amount has more value sooner than it is accepted. The time value of money is also referred to as the present discounted value.
It is a computing of a company’s cost of capital where each capital category is weighted proportionately. Capital sources of all kinds- preferred stock, common stock, and bonds are admitted in WACC calculations.
DCF
Discounted Cash Flow refers to a method of valuing a company that is commonly used by private company investors. Unlike the market valuation method described in the Pricing entry, the discounted cash flow method estimates company value without resorting to the price-earnings ratios of similar publicly held companies.
The premise of the method is that company value can be estimated by forecasting the future performance of the business and measuring the surplus cash flow generated by the company. The surplus cash flows and cash flow shortfalls are discounted back to a present value and added together to arrive at a valuation. The discount factor used is adjusted for the financial risk of investing in the company. The mechanics of the method focus investors on the internal operations of the company and its future.
Like any other valuation method, the discounted cash flow method has its shortcomings. Since it focuses only on the generation of cash flow it ignores outside factors that affect company value, such as price-earnings ratios. It also ignores asset values and other internal factors that can reduce or increase company value.
Nonetheless, it is a commonly used method in venture capital financings because it focuses on what the venture investor is actually buying, a piece of the future operations of the company. Its focus on future cash flows also coincides nicely with a critical concern of all venture investors, the company’s ability to sustain its future operations through internally generated cash flow.
The discounted cash flow method can be applied in six distinct steps. Since the method is based on forecasts, a good understanding of the business, its market and its past operations is a must. The steps in the discounted cash flow method are as follows:
Develop accurate, debt-free projections of the company’s future operations. This is clearly the critical element in the valuation. The more closely the projections reflect a good understanding of the business and its realistic prospects, the more confident investors will be with the valuation its supports.
Quantify positive and negative cash flow in each year of the projections. The cash flow being measured is the surplus cash generated by the business each year. In years when the company does not generate surplus cash, the cash shortfall is measured. So that borrowings will not distort the valuation, cash flow is calculated as if the company had no debt. In other words, interest charges are backed out of the projections before cash flows are measured.
Estimate a terminal value for the last year of the projections. Since it is impractical to project company operations out beyond three to five years in most cases, some assumptions must be made to estimate how much value will be contributed to the company by the cash flows generated after the last year in the projections. Without making such assumptions, the value generated by the discounted cash flow method would approximate the value of the company as if it ceased operations at the end of the projection period. One common and conservative assumption is the perpetuity assumption. This assumption assumes that the cash flow of the last projected year will continue forever and then discounts that cash flow back to the last year of the projections.
Determine the discount factor to be applied to the cash flows. One of the key elements affecting the valuation generated by this method is the discount factor chosen. The larger the factor is, the lower the valuation it will generate. This discount factor should reflect the business and investment risk involved. The less likely the company is to meet its projections, the higher the factor should be. Discount factors used most often are a compromise between the cost of borrowing and the cost of equity investment. If the cost of borrowed money is 10% and equity investors want 30% for their funds, the discount factor would be somewhere in between.
Apply the discount factor to the cash flow surplus and shortfall of each year and to the terminal value. The amount generated by each of these calculations will estimate the present value contribution of each year’s future cash flow. Adding these values together estimates the company’s present value assuming it is debt free.
Subtract present long term and short term borrowings from the present value of future cash flows to estimate the company’s present value.
The following chart illustrates the computations made in the discounted cash flow method. The chart assumes a discount factor of 13% and uses the perpetuity assumption to generate a residual value for the cash flows after the fifth year. The numbers contained in the Discount column represent the present value of 1.00 discounted back at 13% per year.
|
|
Year |
Cash Flow |
Discount |
Present Value |
|
|
1 |
$ -50,000 |
0.885 |
$ -44,250 |
|
|
2 |
10,000 |
0.783 |
7,830 |
|
|
3 |
60,000 |
0.693 |
41,580 |
|
|
4 |
150,000 |
0.613 |
91,950 |
|
|
5 |
310,000 |
0.543 |
168,330 |
|
Residual value |
|
2,384,615 |
0.543 |
1,294,846 |
|
Present value of projected cash flow |
|
|
|
1,560,286 |
|
Subtract: Outstanding debt |
|
|
|
-150,000 |
|
Present Value |
|
|
|
$1,410,286 |
Using the perpetuity assumption to determine the residual value was done by dividing the fifth year’s cash flow ($310,000) by the discount factor (13%). This resulting value represents the value of the company at the end of the fifth year and must be further discounted back to the present value, as shown in the chart.
Since the discounted cash flow method can only estimate value using agreed-upon assumptions, it is always wise to compare the valuation generated using this method with valuations generated using other methods, such as the market valuation method. Also, changing the assumptions in the calculations can create large swings in “value.” Because of this, it is wise to test the assumptions used carefully.
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This glossary post was last updated: 30th December, 2021 | 0 Views.