Discounted cash flow method is one of the most effective business valuation methods. Let's learn about this discount method with HVA!
What is discounted cash flow?
What is discounted cash flow? Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on expected future cash flows. This method determines the current value of a business by predicting the amount of cash that the business can generate in the future.
Discounted cash flow formula
Free cash flow (DFC) is a concept in finance used to value a business or project by assessing profitability based on profits and expected future cash flows.
The basic formula for determining the present value of a future cash flow in discounted cash flow method To be:
DFC = CF1/(1+r)^1 + CF2/(1+r)^2 + CF3/(1+r)^3 + … + CFn/(1+r)^n
In there:
- CF: Cash flow during the period
- r: Interest rate or discount rate
- n: Number of periods
- DCF, also known as discounted cash flow model, helps determine the present value of expected future cash flows.
Discounted Cash Flow Method Example you are evaluating a portfolio with the following expected cash flows:
- Phase 1: $1,000 in year 1
- Phase 2: $1,500 in year 2
- Phase 3: $2,000 in year 3
The discount rate applicable to this project is 10% (0.10).
To calculate the present value (PV) of each period, apply discounted cash flow formula:
PV = CF / (1 + r)^n
- For phase 1: PV = $1000 / (1 + 0.10)^1 = $909.09
- For phase 2: PV = $1500 / (1 + 0.10)^2 = $1210.74
- For phase 3: PV = $2000 / (1 + 0.10)^3 = $1652.89)
The total present value of all cash flows is calculated by adding the present values:
Total present value = $909.09 + $1210.74 + $1652.89 = $,772.72
Therefore, the present value of the project is based on discounted cash flow model futures and discount rate 10% is $3,772.72.
Advantages and disadvantages of discounted cash flow stock valuation
Discounted cash flow method (DCF) is a popular tool widely used by investors and financial professionals.
However, DCF also has both advantages and disadvantages. To use this method effectively, investors need to understand its advantages and limitations.
Advantage
- Actual value assessment: Discounted cash flow method helps determine the present value of future cash flows, assisting decision makers in understanding the true value of an investment or project.
- Risk Assessment: This method allows you to evaluate the attractiveness of a project or investment in the face of risk. By applying different discount rates, you can determine the impact of risk on the value of the project.
- Easy to compare: This discounting method makes it possible to compare different projects or investments, even if they have different payback periods.
- Encourages balanced calculation: This method promotes balanced financial calculation, ensuring that all future costs and benefits are considered accurately and comprehensively.
Disadvantages
- Detailed information required: This method requires complete data about the project or investment, including forecasts of future revenues, costs, and cash flows.
- Limitations in predicting the future: DCF cannot anticipate all future uncertainties, such as market fluctuations or changes in business strategy.
- Ignoring non-financial value: This method focuses on financial factors, so it does not take into account non-financial value such as brand, reputation or social impact.
Steps to calculate the discounted cash flow value of a business
Here are 5 steps to calculate discounted cash flow (DCF) of a business that you should not miss:
Step 1: Make a financial budget for the business
Start by forecasting your company's future revenue. Use historical data and external factors to estimate expected revenue in the coming years.
Financial projections include:
- Expected revenue
- Cost and gross profit
- Investments and cash flows from operations
Step 2: Determine “Free Cash Flow” (FCF)
Basic formula to calculate FCF:
FCFF = EBIT x (1 – corporate income tax rate) + depreciation – capital expenditure – increase or decrease in working capital
Step 3: Calculate some discount factors
The discount factor, expressed as 1/(1+r)^n in the formula, tells us what fraction of the initial value the present value of a future cash flow will be.
Usually, r is replaced by WACC (Weighted Average Cost of Capital). WACC reflects the risk level of future cash flows, with the higher the WACC, the greater the risk and vice versa.
This leads to the relationship: as the discount rate decreases, the present value of the firm also decreases and vice versa.
Formula: WACC = (E / V x Re) + ((D / V x Rd) x (1-T)
In there:
- E: Market value of equity
- D: Market value of debt
- V: Total capital value (Equity + Debt)
- E/V: Equity Ratio
- D/V: Debt to equity ratio
- Re: Cost of equity
- Rd: Cost of debt (interest rate on debt)
- T: Tax rate
Step 4: Calculate the terminal values
Terminal Value is the value that an investment or Asset Management expected to be achieved by the end of a specified period or phase.
Terminal Value represents the Free Cash Flows of the business in the years following the forecast period. It is basically the limit of the sum of the terms CF/(1+r)^n as n goes to infinity (where n > 5).
To calculate this value, assume the annual growth rate of free cash flow (CF) is g. The terminal value is then calculated using the formula:
Terminal Value = [FCF x (1 + g)] / (d – g)
In there:
- FCF: Free cash flow at the end of the forecast period
- g: Long-term growth rate
- d: Discount rate (usually WACC)
Step 5: Add the discounted cash flows together
After calculating the discounted cash flows (DCF) and terminal value, add all these values together to determine the enterprise value.
Note: Discounted cash flow method DCF is a powerful tool for investment valuation. However, to achieve accurate results, the above steps need to be performed carefully, while using reasonable forecasts for future cash flows and discount rates. The above article has helped you better understand discounted cash flow method. If you still have questions about the concept or calculation of this method, please contact us immediately. HVA for detailed answers!
