- Discounted cash flow (DCF) valuation is a method for valuing a business or investment.
- DCF considers expected future cash flows to estimate a business or investment’s present value.
- DCF is only one of many ways to value a business or investment.
There are many ways to value a company. A common method is discounted cash flow (DCF) valuation (sometimes called DCF analysis, DCF model or DCF valuation). Businesses use DCF valuation to indicate the present value of their company, often for the benefit of investors. DCF is used to value investments as well.
It’s important for business owners to understand how the DCF business valuation method works and the benefits of using this valuation method.
What is DCF valuation, and how is it used?
DCF is a valuation method that uses expected future cash flows to estimate the value of a company or investment. DCF is used to determine the present value of an investment, information that would be helpful to anyone who wants a more accurate assessment of an investment opportunity. This calculation makes projections about an investment’s future earnings potential by weighing factors like future costs and benefits.
In investment banking, DCF can help determine how much you could gain from an investment in terms of actual value. DCF calculations factor in what’s known as the "time value of money." The time value of money assumes a dollar increases in value over time since it can be invested. Therefore, the value of a dollar flowing in or out of a business today is worth more now than in the future.
A DCF valuation helps determine a business’s overall value. This helps investors and corporate finance professionals to better understand how much an organization is worth.
DCF valuation is a complex topic; understanding these following business terms can help you better understand DCF and related topics.
- Terminal value: The value of a business beyond your forecast period
- Present value: The current value attributed to a future amount of money or cash flow stream
- Growth rate: How quickly a stock’s cash flow per share has grown, usually during the last three to five years
- Free cash flow: The cash left over once a business pays for capital expenditures and operating expenses
- Discount rate: The rate of return used to determine the present value of future cash flows within a DCF analysis
The DCF formula
The DCF formula amounts to the sum of cash flow in each financial period, divided by one plus the discount rate.
The formula for calculating DCF is as follows:
DCF = CF1/(1+r)1 + CF2/(1+r)2 + CFn/(1+r)n,
CF = cash flow for the given year
r = discount rate
Each year’s cash flow helps represent the amount of money a business or investment has on hand, whether to reinvest in the company or for simpler goals like paying employees and covering recurring expenses.
The discount rate is a figure assigned to future costs and benefits to represent their present value. This rate reflects the company’s cost of capital, otherwise known as the return a company has to make to justify the costs involved in a capital project. Examples could include interest rate and loan payments, or shareholder dividend payments. They are usually based on the weighted average cost of capital (WACC).
DCFs can be added together, producing the net present value (NPV) of an investment opportunity within a forecasting period. The higher the NPV, the more valuable a project or investment is. The lower this figure, the more difficult it will be for you to obtain a return on investment. This formula requires you to forecast a business’s cash flows, determine the appropriate discount rate and calculate an NPV that accurately reflects the financials of your project or investment opportunity.
What is WACC?
The weighted average cost of capital, or WACC, is the rate at which a business is expected to pay its investors or security holders to finance its assets. In simpler terms, WACC is how much a company has to pay lenders, investors or shareholders (also known as the cost of equity).
WACC helps you determine the practicality of investing in a new project or business. The same is true for business owners who might be looking to take on a new business project but want to understand how worthwhile it is as an investment. This calculation represents the minimum viable return needed in order to satisfy creditors and providers of capital.
Let’s say you want to invest $10 million in a project with a 5% WACC (thus giving you a discount rate of 5%). The project you’re investing in is set to last for five years and its estimated cash flow looks like the below:
The DCF on this project would follow the schedule below:
|Year||Cash Flow||DCF (Nearest Dollar)|
The total DCF for this period, therefore, would be $15,988,840. When we subtract the initial $10 million investment, we’re left with $5,988,840 — a sizable NPV that signifies a solid return on this investment.
DCF model pros and cons
The DCF business valuation model has both benefits and drawbacks. This calculation may not be right for everyone or every scenario, but it is often helpful to gauge the financial benefits of a potential investment.
A final word on DCF valuation
Although DCF offers several benefits, it’s just one of many tools used to value a business or investment decision. All investments come with a risk of loss, even despite your best efforts to calculate potential outcomes. That’s why it’s important to consider every aspect of an investment opportunity before investing. A financial professional can help you navigate your options and weigh your own models, so you can invest confidently.