Investment or project appraisal is crucial for making prudent investment decisions. It is important for investors to know the present value of a project or investment to decide whether to proceed with it or not. There are several methods for evaluating a project, a company, or an asset, and discounted cash flow (DCF) is one of them. In this article, you can find out more about What is discounted cash flow and why it is important for your business, its pros and cons, and also tutorial videos.
What is Discounted Cash Flow (DCF)?
DCF is the method that forms the foundation of several other methodologies used for project or investment appraisal. Discounting is the method of reducing the value of future cash flows so that we can compare them to the current value. So, DCF model gives us the present value (PV) of the future cash flows from an investment.
DCF method employs the concept of time value of money while evaluating an investment. The time value of money refers to the concept that money available today is worth more than the same amount of money that would be available in the future.
This happens mainly due to two reasons, (i) inflation erodes the value of money and (ii) interest earning capacity of money. This is the reason why the value of a rupee today is considered more than what its value would be after a year.
DCF method evaluates an investment or project on the basis of the expected future cash flows, i.e., the amount of money it is expected to generate in future. It basically makes an estimate of the value of the money that an investor would be receiving from an investment adjusted for the time value of money.
To arrive at the estimate, all future cash flows from the investment are calculated and then discounted at an annual discount rate. This gives us the present value (PVs) of the future cash flows from the investment. Cash flows refer to the difference between cash inflows (benefits) and cash outflows (costs).
To calculate DCF, we need two things, the expected cash flows from the investment and the discount rate. The weighted average cost of capital (WACC) is usually taken as the discount rate for this purpose. WACC is the average cost of raising money from debt and equity, the two main sources of financing a business.
The Formula for DCF
DCF = [CF1 / (1+r)1] + [CF2 / (1+r)2] + … + [CFn / (1+r)n]
CF = Cash flows for a given year
r = Discount rate (WACC). It is usually the expected rate of return on an investment
n = Time in years before the future cash flow occurs
Types of DCF Techniques
There are mainly two types of DCF methods – NPV(Net Present Value) and IRR (Internal Rate of Return)
NPV Method: In the NPV method, expected cash inflows are discounted to get their present value (PV). Then the initial cost of investment and other cash outflows are deducted from the PV of the future cash flows. This gives an estimate of net present value (NPV).
NPV = [CF1 / (1+r)1] + [CF2 / (1+r)2] + … + [CFn / (1+r)n] – Initial Investment Cost
In other words, if we subtract the initial cost of the investment and other cash outflows from DCF, we get NPV. NPV is actually the difference between the present values (PVs) of cash inflows and cash outflows or costs.
NPV gives us an estimate of the net return on an investment. A positive NPV or NPV higher than the current cost of the investment project means that the investment is desirable.
IRR Method: The internal rate of return (IRR) is the discount rate at which NPV of all cash flows from an investment or project becomes zero. So, IRR is the discount rate that equalizes PVs of expected cash inflows to PVs of the anticipated cash outflows. An investment is considered desirable if IRR is higher than the minimum fair rate of return.
How Investors Use Discounted Cash Flow Analysis to Value a Business
The DCF is an important method for evaluating and comparing investment projects. If the price of a property or investment is less than the sum of discounted cash flows, then it is highly rewarding or profitable from the point of view of investors. Such an investment is termed as undervalued.
On the other hand, an overvalued investment is the one whose price is higher than the sum of discounted cash flows. Such an investment is not considered attractive by investors. To put it simply, if DCF value is higher than the current cost of the investment, the investment is considered attractive.
DCF method has wide applications in sectors like investment finance, real estate development, and corporate financial management. It helps professional investors make frugal investment decisions. With the help of NPV and IRR methods, investors can compare the value of bonds, securities, and shares before investing in them.
It is also widely used by financial analysts and project managers to evaluate a project or investment before undertaking it. DCF method can be used to determine the absolute value of a company as well. In fact, this method can be used to assess the value of anything that produces an income stream or cash flows.
Advantages of the DCF method
As DCF method takes into account the crucial factors like cost of equity, WACC, and growth rate, it can give the closest estimate of the intrinsic value of an asset or business.
Secondly, it is based on the estimate of future cash flows, which is considered more objective and dependable than many other subjective accounting policies.
Thirdly, it is comparatively less affected by non-economic factors and short-term market conditions.
Fourthly, other methods used for investment or project evaluation can give unreliable estimates, if the market or a particular sector of the market is overvalued or undervalued. DCF method is free from these shortcomings.
Limitations of the DCF Method
DCF method does have some inherent weaknesses, which can be attributed to a large number of assumptions required by the method.
The results obtained from the method are, therefore, very sensitive to even slight variations in these assumptions, especially those related to discount rates and perennial growth rate. Any change in these variables can cause large fluctuations in the DCF value.
If the future expected cash flows cannot be predicted accurately due to uncertain business conditions, we cannot get an accurate DCF value. This makes the DCF method vulnerable to errors.
Moreover, business conditions do not remain stable. Any change in business expectations of a company will, therefore, require constant revision in DCF valuation. As such this method is not considered suitable for the short-term investment decisions.
So, before employing the DCF model, it is important to weigh its advantages and disadvantages. The method can work really well if future cash flows from an investment can be predicted accurately.
Despite having a few shortcomings, DCF or NPV is considered one of the most reliable valuation methods available. In general, a financial analyst uses DCF with other valuation methods to have checks and balances and arrive at the best possible estimate of the intrinsic value of an asset or company.
DCF Tutorial Videos:
Image Credit: Beone-solution.com
Video Credit: Assist Knowledge Development
& Chegg Tutors