The basic formula for discounted cash flows, or DFC, is as follows:
DFC = FC + FC2 + FC3 + FC4 + FC5 + FC(n)
(1 + r) (1 + r)² (1 + r)³ (1 + r)⁴ (1 + r)⁵ (1 + r)ⁿ
DFC = sum of the discounted periodic cash flows and the terminal value cash flow
FC = cash flow (or net income or free cash flow) for each period, usually one year = discount rate
Taking an example with figures, a DFC model could look like this.
Company X, currently trading at €375 per share, has the following projected cash flows per share:
Year 1 Year 2 Year 3 Year 4 Year 5 Years 6–15
€20 € 40 € 60 € 80 € 100 € 400
Assumption : Discount rate of 7%
Terminal value : 10 years after years 1 to 5
Cash flows discounted at 7% to the power of each year, canadian email address list while years 6 through 15 (the terminal value) discounted at 7% to the tenth power would be:
Year 1 Year 2 Year 3 Year 4 Year 5 Years 6–15
€18.69 € 34.94 € 48.98 € 61.04 € 71.30 € 203.34
The sum of the annual discounted cash flows is €438.29 per share. An investor might conclude that Company X appears to be undervalued, since the price per share (€375) is lower than the discounted cash flows.
Benefits and limitations of discounted cash flow
Discounted cash flow analysis can benefit business managers and investors in several ways. Among other things, the concept:
It attempts to establish the intrinsic value of a stock, asset or project, independent of the market value or price. A valuation based on discounted cash flows might, for example, prevent a business owner from investing in an expansion that will not pay off.
Consider key expectations and assumptions, such as a company's expected growth rate and discount rate, as well as the company's useful life.
It can also be used to determine the internal rate of return on an investment or business project, and for cost-benefit analysis by investment banks of proposed mergers and acquisitions.
It can be used in scenario and sensitivity analysis, sometimes called "what if" analysis. For example, investors might increase the discount rate by one percentage point to see how the theoretical value of a company changes.
On the other hand, discounted cash flow has some disadvantages, such as:
It is based on assumptions and expectations, and this calculation is very sensitive to changes in those assumptions and expectations, making the conclusions subject to error.
Because discounted cash flow examines a stock or business project in isolation and ignores comparable companies or projects, there is no basis for relative valuation – that is, Company X is not compared to its competitors. Analysts and fund managers often use discounted cash flow analysis in conjunction with relative value comparisons to make investment decisions.
Frequently Asked Questions About Discounted Cash Flow
How is discounted cash flow calculated?
Discounted cash flow is calculated by summing each projected cash flow, which is reduced to a present value by the discount rate raised to the power of the number of future periods for the cash flow. Most calculations and analyses use years as the time periods.
What is an example of discounted cash flow?
Everyday examples include lottery prizes that offer a cash option, as well as savings bonds sold by businesses and government agencies. For example, consider a €100 million prize that pays the winner €4 million a year for 25 years. But what if the winner chooses to receive the amount in cash and at the time? The entity awarding the prize could use an appropriate discount rate of 3%, and the current lump sum would be €47.8 million.
Are NPV and DCF the same thing?
They are similar, but not exactly the same. Net present value (NPV) uses the same discounting process. But after calculating the discounted cash flow, the stock price or current value of the asset is subtracted. The difference is the net present value. A positive NPV might indicate that a stock is worth buying at the current price, or that investing in a business venture makes financial sense.