What is a discounted cash flow model (DCF)?
A discounted cash flow model (DCF) is a valuation model that forecasts a company’s cash flows and discounts them to find its current net present value. DCF is widely used in academic research and also applied in real-world settings. The DCF model is a valuation model for companies that estimate their ability to generate future cash flows. This is usually presented in comparison to the company's market value.
Comparing the company to a market-based valuation like a comparable company analysis (CVA), the DCF model emphasizes that value is derived from companies' ability to generate future cash flows in the future for its shareholders.
Types of DCF:
Unlevered DCF approach :
Forecast and discount the operating cash flows. Then, when you have a present value, just add any non-operating assets such as cash and subtract any financing-related liabilities such as debt.
Levered DCF approach:
Forecast and discount the cash flows that remain available to equity shareholders after cash flows to all non-equity claims (i.e. debt) have been removed.
The DCF Formula for Discounted Cash Flow Analysis:
Although this may seem intimidating a first, we're going to go through each component and break it down for you!
DCF - Discounted Cash Flow
r - the interest rate or discount rate
n - the period number
Cash Flow (CF):
Cash Flow represents the net cash payments an investor receives for owning given security. When building a financial model of a company, the CF is typically what's known as unlevered free future cash flows. When valuing a bond, the Cash Flow would be interest and or principal payments.
Discount Rate (r)
Discount rates are typically a company's weighted average cost of capital (WACC), which means the rate at which investors expect to be repaid on their investments in the company. For a bond, the discount rate would be equal to the interest rate on the security.
Period Number (n)
Each cash flow is associated with a certain period of time. Common periods are years, quarters, or months. The periods can be equal or different; if they're different, they’re expressed as percentages of 1 year.
What is the Discounted Cash Flow (DCF) Formula Used For in regards to Future Cash Flows?
The discounted cash flow formula is used to determine the value of a business or security. The DCF comprises the present value by discounting future cash flows funds relative to what they will be worth given a required return on investment (the discount rate).
Examples of Uses for the DCF Formula:
- To evaluate the value of a business
- To assess the merit of an object for investment purposes to show expected cash flows and future cash flows
- To determine the marketability of a bond on account of interest rates
- To calculate the profitability or fair price-per-share ratio when dealing with stocks in a company.
- To ascertain whether or not there is money to be saved from implementing cost-saving initiatives
What Does the Discounted Cash Flow Formula Tell You?
When assessing a potential investment, it’s important to account for the time value of money or the required rate of return.
The DCF formula takes into account how much return you expect to earn and the resulting value is how much you would be willing to pay for something that offered a rate of return competitive with your expectations.
If you pay less than the DCF value, your rate of return will be higher than the discount rate.
If you pay more than the DCF value, your rate of return will be lower than the discount.