Discounted Cash Flow - What Is DCF? & Why Is It Important?

Discounted Cash Flow (DCF) is one of the most used valuation techniques for finding the intrinsic value of any business, stock, or investment opportunity. It differs from other relative valuation techniques that rely on the market prices of stocks or company peer comparisons. Instead, discounted cash flow valuation is centred on the fundamental business model and on the cash the business can reasonably be expected to make. 

In this guide, you will learn how to complete a DCF Method step by step, learn the DCF valuation Formula, and have a clear DCF valuation Example that illustrates the practical use of DCF Analysis, which is useful for almost all investors and analysts. 

 

What is the DCF Valuation Method?

The DCF valuation method is a technique that involves calculating the investment's present value after making future cash flow forecasts using a specific technique to discount future cash flows (or future cash flows to be received) to arrive at a present value. 

In simple terms: 

DCF answers one basic question: 

What is the value of the future cash flows today?

The value of a pound this year is not equal to the value of that pound the following year, and this implies that cash flows will have a lower value in the future (due to risk, inflation and opportunity costs). 

Importance of Discounted Cash Flow Valuation

Because of the focus on how much a business can earn in the long run, rather than how the stock market fluctuates, the business can centre its analysis on the forecasting of cash flows of the business. Investors apply the DCF in the following ways:

- To figure out the true business value.

- To determine the true value of a stock, whether it is selling too low or too high.

- To help arrive at an appropriate decision on how long to invest.

- To help dampen the risks of investing based on emotions or the buzz.

For these reasons, DCF analysis is of utmost importance to value investors and business analysts.

Core Concept Behind DCF Analysis

The DCF valuation method aligns its principles with the following:

1. Future Cash Flow - Businesses are valued by the cash they generate

2. Time Value of Money - Money today is worth more than the same money in the future

3. Risk Adjustment - Cash flow with greater risks will be discounted at a greater rate.

The principles above are combined to determine the cash flow through the DCF valuation formula.

Explaining The DCF Valuation Formula

The DCF valuation formula is simple. 

Where:

CFₜ= Cash flow in year t

r= The discount rate

t= The time period

 

The DCF analysis divides the overall valuation into two:

1. The cash flow prediction period present value

2. The value of the present terminal value

DCF valuation method major factor components:

 

1. Free Cash Flow

FCF is the amount of cash the business is left with after covering operational costs and capex. 

FCF = Operating Cash Flow - Capital Expenditure

In discounted cash flow valuation analysis, FCF is preferred over the cash flow of the business because it shows the cash available to the entire set of capital parts.

 

2. Forecast Period

The forecast period spans between 5 to 10 years. In this phase, cash flow is estimated based on a few parameters categorised into:

How quickly is Revenue going to increase? 

What is going to be the value of Profit margins?

What are the Tax costs going to be?

How much is Capital expenditure going to be? 

When DCF method is explained and applied accurate forecasting is a must.

 

3. Discount Rate (WACC)

The discount rate considers risk and opportunity cost. The rate most often used is called the Weighted Average Cost of Capital (WACC).

WACC = (E/V x Cost of Equity) + (D/V x Cost of Debt)

A WACC that is too high will decrease the company valuation, and too low will increase it, thus making WACC a sensitive measurement that must be used in DCF analysis.

 

4. Terminal Value

The Terminal Value equation captures the other cash flows beyond the forecasting period.

Where, 

- g is the percentage rate of growth into perpetuity, and

- r is the discount rate

Due to the nature of growth into perpetuity, terminal values often become a bulk of the overall DCF valuation.

 

DCF Method Step by Step

Step 1: Estimate Future Free Cash Flows

Forecast each year cash flow for the whole duration of the forecasting period.

 

Step 2: Pick the Discount Rate

Either WACC or the required rate of return.

 

Step 3: Compute the Terminal Value

Use the perpetual growth equation.

 

Step 4: Discount Cash Flows

Future cash flows should be brought back to present value.

 

Step 5: Total All Present Values

This amount reflects the business' intrinsic value.

Projecting Cash Flows from a DCF Valuation Perspective

Let’s look at a simple DCF valuation example.  

 

Assumptions:

Forecast Period: 5 Years

Starting Free Cash Flow: 10 Mn USD

Forecast Growth Rate: 10% per annum

Discount Rate: 12%

Terminal Growth Rate: 4%

 

Cash Flow Projections:

Year 1: 10 Mn USD  

Year 2: 11 Mn USD  

Year 3: 12.1 Mn USD  

Year 4: 13.3 Mn USD  

Year 5: 14.6 Mn USD  

 

Terminal Value:

TV = 14.6 x (1.04) / (0.12 - 0.04) = 189.8 Mn USD

The DCF technique of cash flow valuation of the business shows the intrinsic worth of the business, as it gives the DCF value of approximately 145 Mn USD, on discounting the estimates of the present and future cash flows of the business and the present value of the terminal value.

 

Utilizing the results of DCF Valuation

When a DCF valuation is done:  

If the Market Price > DCF Value: Overvalued

If the Market Price < DCF Value: Undervalued

Note: a DCF valuation should always be backed up with qualitative and business know-how.  

 

DCF Valuation Method Pros 

• Long-term fundamentals  

• No market sentiment dependence  

• Industry agnostic  

• Good for estimating intrinsic value  

For the above reasons, the DCF valuation method is widely used by professional investors  

 

DCF Valuation Method Cons

While the DCF analysis has many pros, the following are the major cons:  

• Sensitive to assumptions.  

• Companies with losses or startups are difficult for DCF.  

• Results can be dominated by the terminal value.  

• Valuation can be affected by changes to the discount rate.  

These are the reasons why DCF method explained should not be used mechanically.  

 

Tips to Improve DCF Analysis

• Avoid aggressive growth assumptions.  

• Incorporate sensitivity analysis.  

• Use approaches with different assumptions to compare your results.  

• Terminal growth rates should be realistic.  

• Update your assumptions often.  

The discipline of the above steps will improve the reliability of discounted cash flow valuation.

 

DCF Valuation vs Other Valuation Methods

Method	Basis	Best Used For
DCF Valuation Method	Cash flows	Intrinsic valuation
P/E Ratio	Earnings	Quick comparison
EV/EBITDA	Operating profit	Capital-intensive firms
Book Value	Net assets	Financial institutions

 

Each method serves its own purpose, but DCF valuation tends to be the most theoretically sound.

 

Conclusion

The DCF valuation method acts as an investment barrier to most due to its complexity. However, once an investor becomes familiar with its methodology, the complexity dissipates. DCF analysis takes into consideration dozens of variables that, once accurately estimated/realised, significantly pulls upward the expected value of the firm. 

Other valuation methodologies become less effective as the irrefutable assumption that every business must eventually become profitable.

Remember one golden rule: DCF valuation is based on informed judgment rather than accuracy.

 

DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.