All About Discounted Cash Flow, With Formulas And Examples

What is discounted cash flow?

Discounted cash flow (DCF) is a method used to assess the value of an investment by calculating how much cash it will generate in the future. It helps you determine the fair value of an investment today by adding up its projected cash flows in the future.

At the heart of the discounted cash flow model is the theory of the time value of money, according to which money in the present is of more value than money in the future. This is because money in the present can be invested and, in turn, earn more money. The DCF model, therefore, involves discounting cash generated by a business in a given period in the future (say, three years from now) back to the present.

A DCF valuation works on assumptions about a company’s sales, cash flows, profit margins, and growth in the future. But, despite not being grounded in actual numbers, discounted cash flow analysis – if done right – is a very reliable tool that can help you evaluate a project, a stock purchase, or any kind of business investment.

Once discounted cash flow is calculated, it is compared with the initial cost. If the DCF is higher than the investment cost, the venture can be considered a profitable one. If the DCF is lower than the current cost, the investment might not be worth your time or, at the very least, requires more research and analysis before you commit to it. The higher the DCF, the greater the expected return on investment.

What is DCF used for?

Discounted cash flow is used in situations where you are investing money in the present with the expectation of making more money out of it in the future. A DCF valuation comes in handy when an investor is looking to invest in or acquire a company and needs to evaluate it. Or, they may use it before buying shares in a company. Entrepreneurs may also turn to the DCF model before starting on a new project or making important financial decisions.

As such, the DCF formula (which we will discuss shortly) can be used to evaluate an entire business or its stocks and bonds. It can be used to compare different companies. Discounted cash flow can aslo be used to assess a project or investment within the business, or in fact any decision that has an impact on cash flow.

How do you calculate DCF?

The discounted cash flow formula is:

DCF = CF1 / (1 + r) ^1 + CF2 / (1 + r) ^2 + ... + CFn / (1 + r) ^n 

The components of the DCF formula are:

• CF: Cash flow
• r: Discount rate, or the rate of return expected on the investment. It is converted from percent to decimal form. Typically, investors and analysts use a company’s weighted average cost of capital (WACC) as the discount rate. Weighted average cost of capital is defined as the average cost of capital from all of a company’s sources – such as stocks (common and preferred), debt, bonds – after tax. Simply put, WACC is what a business expects to pay to finance its operations.
• n: Period number, which represents the time period associated with each cash flow. In the discounted cash flow formula above, CF1 represents cash flow in the first year, CF2 is cash flow in the second year, and CFn is cash flow for any additional years.

How to use the discounted cash flow calculator

Here's an example: Company ABC is planning a new product launch. The initial cost of investment is SGD 15 million. The company’s WACC is 10%, which is also its discount rate. The investment period is five years. The forecasted cash flows are as follows:

Now, the DCF calculation:

This DCF figure is higher than the initial investment cost of SGD 15 million, which points to a profitable investment.

Terminal value

A typical discounted cash flow model uses cash flow forecasts for five years (it can be longer for certain industries such as mining, oil and gas, infrastructure, etc). However, to know what the investment is worth after the initial forecast period, we need to calculate terminal value. As it gets increasingly difficult to forecast cash generation far into the future, terminal value assumes that an investment will continue to perform or grow at a set rate forever after the initial forecast period has passed. Terminal value is a crucial component of the DCF model because it makes up a large portion (close to 50%, by some estimates) of a company’s value.

In the example given above, let’s assume the forecasted cash flow beyond the fifth year is SGD 20 million. Therefore:

Terminal value = 20 / (1 + 0.10) 5

Terminal value = SGD 12.4 million

This takes the total DCF to SGD 33.9 million

The 5 steps in DCF calculation

How do you analyse DCF?

Continuing with the previous example, Company ABC's SGD 15-million product launch can be considered a safe and profitable venture given that the discounted cash flow for five years amounts to SGD 21.5 million. However, if the initial investment were SGD 25 million instead of SGD 15 million, the projected return on investment would have fallen short. The company would have suffered a loss of SGD 3.5 million and the project would, therefore, have been deemed unprofitable.

There’s another way to look at the discounted cash flow figure. If Company ABC is expecting a 10% return on its investment and plans to get it within five years and no longer, the DCF figure – SGD 21.5 million in this case – represents the highest amount it should spend on the product launch. An investment amount higher than this would be loss-making while a lower investment cost would definitely be more welcome.

Here's another example: An investor is looking to put SGD 100,000 into a small business for a three-year period. The discount rate (WACC) is 5% and the projected cash flows are SGD 20,000 in Year 1, SGD 35,000 in Year 2, and SGD 45,500 in Year 3. Now, the calculation:

Given that the DCF (SGD 90,090) is lower than the initial investment cost (SGD 100,000), the investor would be better off putting their money into a more profitable venture.

Advantages of DCF

• A DCF valuation can be done for any investment/project where future cash flows can be reliably estimated. You can use the DCF model if you plan to acquire or sell a business and need to evaluate it, measure the profitability of a project, assess the value of a stock, or gauge the outcome of an initiative (entering a new market, for instance). Businesses can even use DCF to check the feasability of their budgets and other financial strategies.
• DCF calculations use cash data, which reflect a company’s actual financial position. This does away with the need to compare with rival companies.
• Discounted cash flow models are versatile as they can be tweaked and adjusted to create various financial scenarios with different cash flows and futures. This allows investors to compare, analyse, and make informed choices.

Limitations of DCF

• The biggest drawback of the discounted cash flow model is that it is based on assumptions, not actual figures. The result is also an estimate. If projections aren’t computed carefully, the results can be far from the truth. An unreliable DCF analysis can lead to heavy losses. 
• Future cash flow forecasts can be impacted by a variety of factors over which businesses have little to no control. These include the state of the economy, market demand, competition, and other unforeseen circumstances.
• The DCF model requires significant data. Even if you have access to the three financial documents – the income statement, cash flow statement, and balance sheet – compiling the data, making various calculations, and then analysing the results will take a fair amount of time.

DCF vs NPV

Discounted cash flow is sometimes used interchangeably with net present value (NPV), but there is a difference. Net present value takes the DCF formula further by deducting the initial investment cost from the discounted cash flows. The formula to calculate NPV is:

NPV = CF1 / (1 + r) ^1 + CF2 / (1 + r) ^2 + ... + CFn / (1 + r) ^n – Investment cost

Taking the previously used example, the DCF calculated is SGD 21.5 million. Now, if you deduct the upfront investment cost of SGD 15 million, you get an NPV of SGD 6.5 million.

Net present value can be positive (as in the example) or negative. A positive NPV shows there is additional value to be made from the investment. A negative NPV, on the other hand, shows the upfront cost is greater than the investment’s projected earnings.

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