Discounted Cash Flow Analysis

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Modified on 2011/07/14 15:07 by swathen Categorized as Uncategorized

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Discounted Cash Flow Analysis ¶

Discounted Cash Flow Definition

Discounted cash flow (DCF) is a valuation method used to value an investment opportunity. DCF analysis tells investors how much a company is worth today based on all of the cash that company could make available to investors in the future. It requires calculation of a company’s free cash flows (FCF) as well as the net present value (NPV) of these FCFs. There are three major concepts in DCF model: net present value, discounted rate and free cash flow. All future cash flows are estimated and discounted to give them a present value. The discount rate used is generally the appropriate cost of capital, and incorporates judgments of the uncertainty of the future cash flows.

Formula & Example

Equity value = ∑Annual free cash flow to equity/(1 + cost of equity)^t + residual value/(1 + cost of equity)^t

Enterprise value = ∑Annual free cash flow to firm/(1 + cost of capital)^t + residual value/(1 + cost of capital)^t

Or constant-growth free cash flow valuation model when free cash flow grows at a constant rate g, such that free cash flow in any period is equal to free cash flow in the previous period multiplied by (1+g).

Equity value = Annual free cash flow to equity * ( 1+ g)/(cost of equity – g)

Enterprise value = Annual free cash flow to firm * ( 1+ g)/(cost of capital – g)

Free cash flow to equity is the cash flow available to the company’s common equity holders after all operating expenses, interests, and principal payments have been paid and necessary investments in working and fixed capital have been made. It is the cash flow from operations minus capital expenditures minus payments to debt-holders.

Free cash flow to firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. It is the cash flow from operations minus capital expenditures.

Example: a company is projected to have fluctuating cash flows (e.g. losses of $10,000 in the first two years, a gain of $20,000 in year 3, $45,000 in year 4 and $ 55,000 in the year 5. How much is it worth today?

The cash flows are discounted at a rate acceptable to the investor of 18%.

	Time	                Year 1  Year 2  Year 3  Year 4  Year 5  NPV
Projected future cash flow       -10,000 -10,000  20,000  45,000  55,000	
Residual value                                                     5,000	
Projected annual free cash flow  -10,000 -10,000  20,000  45,000  60,000	
Discounted cash flows            - 8,475 - 7,182  12,173  23,211  26,227 45,953

This leaves a present value of $45,953. It indicates the estimated fair market value of the company today.

Applications

DCF valuation method used to estimate the attractiveness of an investment opportunity. Its analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Although DCF is good for investors to do a reality check, it does have shortcomings. DCF analysis is based on its input assumptions. Small changes in inputs (such as free cash flow forecasts, discount rates and perpetuity growth rates) can result in large changes in the value of a company. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and susceptible to error.